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David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, AO World plc (LON:AO.) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is AO World's Net Debt?
The image below, which you can click on for greater detail, shows that AO World had debt of UK£20.8m at the end of September 2020, a reduction from UK£35.4m over a year. But it also has UK£85.4m in cash to offset that, meaning it has UK£64.6m net cash.
How Strong Is AO World's Balance Sheet?
We can see from the most recent balance sheet that AO World had liabilities of UK£405.4m falling due within a year, and liabilities of UK£84.4m due beyond that. On the other hand, it had cash of UK£85.4m and UK£165.7m worth of receivables due within a year. So its liabilities total UK£238.7m more than the combination of its cash and short-term receivables.
Since publicly traded AO World shares are worth a total of UK£2.03b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, AO World also has more cash than debt, so we're pretty confident it can manage its debt safely.
Although AO World made a loss at the EBIT level, last year, it was also good to see that it generated UK£26m in EBIT over the last twelve months. 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 AO World'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. AO World may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, AO World actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While AO World does have more liabilities than liquid assets, it also has net cash of UK£64.6m. The cherry on top was that in converted 345% of that EBIT to free cash flow, bringing in UK£90m. So we are not troubled with AO World's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for AO World you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
This article by Simply Wall St is general in nature. 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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