Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies A2B Australia Limited (ASX:A2B) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 A2B Australia's Net Debt?
You can click the graphic below for the historical numbers, but it shows that A2B Australia had AU$2.70m of debt in June 2019, down from AU$3.05m, one year before. But it also has AU$19.2m in cash to offset that, meaning it has AU$16.5m net cash.
How Strong Is A2B Australia's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that A2B Australia had liabilities of AU$49.3m due within 12 months and liabilities of AU$1.56m due beyond that. On the other hand, it had cash of AU$19.2m and AU$72.6m worth of receivables due within a year. So it can boast AU$40.9m more liquid assets than total liabilities.
It's good to see that A2B Australia has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that A2B Australia has more cash than debt is arguably a good indication that it can manage its debt safely.
On the other hand, A2B Australia saw its EBIT drop by 7.0% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. 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 A2B Australia'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While A2B 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. Over the most recent three years, A2B Australia recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While it is always sensible to investigate a company's debt, in this case A2B Australia has AU$16.5m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 70% of that EBIT to free cash flow, bringing in AU$10m. So is A2B Australia's debt a risk? It doesn't seem so to us. Another factor that would give us confidence in A2B Australia would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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