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. 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. As with many other companies Anova Metals Limited (ASX:AWV) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Anova Metals's Debt?
The chart below, which you can click on for greater detail, shows that Anova Metals had AU$3.00m in debt in June 2019; about the same as the year before. However, it also had AU$1.09m in cash, and so its net debt is AU$1.91m.
How Healthy Is Anova Metals's Balance Sheet?
According to the last reported balance sheet, Anova Metals had liabilities of AU$1.75m due within 12 months, and liabilities of AU$3.57m due beyond 12 months. Offsetting these obligations, it had cash of AU$1.09m as well as receivables valued at AU$37.6k due within 12 months. So its liabilities total AU$4.19m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Anova Metals has a market capitalization of AU$7.03m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Anova Metals 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.
In the last year Anova Metals had negative earnings before interest and tax, and actually shrunk its revenue by 25%, to AU$2.8m. To be frank that doesn't bode well.
While Anova Metals's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Its EBIT loss was a whopping AU$6.9m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. However, it doesn't help that it burned through AU$536k of cash over the last year. So in short it's a really risky stock. When I consider a company to be a bit risky, I think it is responsible to check out whether insiders have been reporting any share sales. Luckily, you can click here ito see our graphic depicting Anova Metals insider transactions.
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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