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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 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. We can see that Allied Farmers Limited (NZSE:ALF) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Allied Farmers's Debt?
As you can see below, Allied Farmers had NZ$3.04m of debt at June 2021, down from NZ$3.79m a year prior. However, its balance sheet shows it holds NZ$4.54m in cash, so it actually has NZ$1.50m net cash.
How Strong Is Allied Farmers' Balance Sheet?
According to the last reported balance sheet, Allied Farmers had liabilities of NZ$14.9m due within 12 months, and liabilities of NZ$2.83m due beyond 12 months. Offsetting this, it had NZ$4.54m in cash and NZ$15.5m in receivables that were due within 12 months. So it can boast NZ$2.28m more liquid assets than total liabilities.
This short term liquidity is a sign that Allied Farmers could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Allied Farmers has more cash than debt is arguably a good indication that it can manage its debt safely.
Better yet, Allied Farmers grew its EBIT by 163% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Allied Farmers will need earnings to service that debt. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Allied Farmers 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. Happily for any shareholders, Allied Farmers actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While it is always sensible to investigate a company's debt, in this case Allied Farmers has NZ$1.50m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 124% of that EBIT to free cash flow, bringing in NZ$3.7m. So we don't think Allied Farmers's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Allied Farmers is showing 3 warning signs in our investment analysis , and 2 of those make us uncomfortable...
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.
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.
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