Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Adelaide Brighton Limited (ASX:ABC) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Adelaide Brighton's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Adelaide Brighton had AU$579.0m of debt, an increase on AU$509.2m, over one year. On the flip side, it has AU$59.8m in cash leading to net debt of about AU$519.2m.
How Healthy Is Adelaide Brighton's Balance Sheet?
The latest balance sheet data shows that Adelaide Brighton had liabilities of AU$180.7m due within a year, and liabilities of AU$774.9m falling due after that. Offsetting this, it had AU$59.8m in cash and AU$257.7m in receivables that were due within 12 months. So it has liabilities totalling AU$638.1m more than its cash and near-term receivables, combined.
Adelaide Brighton has a market capitalization of AU$1.93b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With a debt to EBITDA ratio of 2.1, Adelaide Brighton uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.8 times its interest expenses harmonizes with that theme. Shareholders should be aware that Adelaide Brighton's EBIT was down 28% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Adelaide Brighton's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Adelaide Brighton recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Adelaide Brighton's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its interest cover was re-invigorating. We think that Adelaide Brighton's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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