The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, National Vision Holdings, Inc. (NASDAQ:EYE) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is National Vision Holdings’s Net Debt?
The chart below, which you can click on for greater detail, shows that National Vision Holdings had US$717.1m in debt in April 2021; about the same as the year before. On the flip side, it has US$453.8m in cash leading to net debt of about US$263.3m.
How Healthy Is National Vision Holdings’ Balance Sheet?
We can see from the most recent balance sheet that National Vision Holdings had liabilities of US$359.8m falling due within a year, and liabilities of US$1.17b due beyond that. Offsetting these obligations, it had cash of US$453.8m as well as receivables valued at US$60.0m due within 12 months. So it has liabilities totalling US$1.02b more than its cash and near-term receivables, combined.
National Vision Holdings has a market capitalization of US$4.10b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While National Vision Holdings’s low debt to EBITDA ratio of 1.1 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.0 times last year does give us pause. So we’d recommend keeping a close eye on the impact financing costs are having on the business. It is well worth noting that National Vision Holdings’s EBIT shot up like bamboo after rain, gaining 81% in the last twelve months. That’ll make it easier to manage its debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if National Vision Holdings can strengthen its balance sheet over time.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, National Vision Holdings generated free cash flow amounting to a very robust 90% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
The good news is that National Vision Holdings’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its interest cover. Zooming out, National Vision Holdings seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet.