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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Ariadne Australia Limited (ASX:ARA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Ariadne Australia Carry?
The image below, which you can click on for greater detail, shows that at December 2021 Ariadne Australia had debt of AU$27.7m, up from AU$22.3m in one year. But on the other hand it also has AU$36.0m in cash, leading to a AU$8.28m net cash position.
A Look At Ariadne Australia's Liabilities
We can see from the most recent balance sheet that Ariadne Australia had liabilities of AU$15.0m falling due within a year, and liabilities of AU$29.9m due beyond that. On the other hand, it had cash of AU$36.0m and AU$2.13m worth of receivables due within a year. So its liabilities total AU$6.84m more than the combination of its cash and short-term receivables.
Of course, Ariadne Australia has a market capitalization of AU$115.8m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Ariadne Australia also has more cash than debt, so we're pretty confident it can manage its debt safely.
Even more impressive was the fact that Ariadne Australia grew its EBIT by 1,102% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is Ariadne Australia's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Ariadne Australia has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last two years, Ariadne Australia created free cash flow amounting to 10% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
We could understand if investors are concerned about Ariadne Australia's liabilities, but we can be reassured by the fact it has has net cash of AU$8.28m. And it impressed us with its EBIT growth of 1,102% over the last year. So we are not troubled with Ariadne Australia's debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Ariadne Australia is showing 4 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.