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Here's Why Austal (ASX:ASB) Can Manage Its Debt Responsibly

Simply Wall St

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. Importantly, Austal Limited (ASX:ASB) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. 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.

View our latest analysis for Austal

How Much Debt Does Austal Carry?

The image below, which you can click on for greater detail, shows that Austal had debt of AU$171.1m at the end of June 2019, a reduction from AU$185.3m over a year. But on the other hand it also has AU$275.7m in cash, leading to a AU$104.6m net cash position.

ASX:ASB Historical Debt, October 22nd 2019

A Look At Austal's Liabilities

The latest balance sheet data shows that Austal had liabilities of AU$474.7m due within a year, and liabilities of AU$221.9m falling due after that. Offsetting this, it had AU$275.7m in cash and AU$227.0m in receivables that were due within 12 months. So it has liabilities totalling AU$193.9m more than its cash and near-term receivables, combined.

Of course, Austal has a market capitalization of AU$1.47b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Austal also has more cash than debt, so we're pretty confident it can manage its debt safely.

On top of that, Austal grew its EBIT by 60% over the last twelve months, and that growth will make it easier to handle its debt. 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 Austal'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, a company can only pay off debt with cold hard cash, not accounting profits. Austal 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. In the last three years, Austal's free cash flow amounted to 40% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

Although Austal's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$104.6m. And we liked the look of last year's 60% year-on-year EBIT growth. So is Austal's debt a risk? It doesn't seem so to us. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Austal insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.