Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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. Importantly, AgroFresh Solutions, Inc. (NASDAQ:AGFS) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 AgroFresh Solutions's Net Debt?
The chart below, which you can click on for greater detail, shows that AgroFresh Solutions had US$405.1m in debt in June 2019; about the same as the year before. On the flip side, it has US$35.9m in cash leading to net debt of about US$369.3m.
How Healthy Is AgroFresh Solutions's Balance Sheet?
According to the last reported balance sheet, AgroFresh Solutions had liabilities of US$63.4m due within 12 months, and liabilities of US$462.0m due beyond 12 months. On the other hand, it had cash of US$35.9m and US$57.0m worth of receivables due within a year. So its liabilities total US$432.5m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$120.9m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we definitely think shareholders need to watch this one closely. After all, AgroFresh Solutions would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 0.31 times and a disturbingly high net debt to EBITDA ratio of 6.2 hit our confidence in AgroFresh Solutions like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, AgroFresh Solutions's EBIT was down 28% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if AgroFresh Solutions can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, AgroFresh Solutions recorded free cash flow worth a fulsome 98% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
To be frank both AgroFresh Solutions's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. After considering the datapoints discussed, we think AgroFresh Solutions has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given the risks around AgroFresh Solutions's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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