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.’ 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. We can see that adesso AG (FRA:ADN1) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does adesso Carry?
The chart below, which you can click on for greater detail, shows that adesso had €45.9m in debt in December 2018; about the same as the year before. But on the other hand it also has €46.2m in cash, leading to a €219.0k net cash position.
A Look At adesso’s Liabilities
We can see from the most recent balance sheet that adesso had liabilities of €101.7m falling due within a year, and liabilities of €42.9m due beyond that. Offsetting this, it had €46.2m in cash and €99.9m in receivables that were due within 12 months. So these liquid assets roughly match the total liabilities.
This state of affairs indicates that adesso’s balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it’s hard to imagine that the €296.8m company is struggling for cash, we still think it’s worth monitoring its balance sheet. adesso boasts net cash, so it’s fair to say it does not have a heavy debt load!
Also positive, adesso grew its EBIT by 23% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine adesso’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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. adesso 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. During the last three years, adesso produced sturdy free cash flow equating to 58% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that adesso has net cash of €219k, as well as more liquid assets than liabilities. And we liked the look of last year’s 23% year-on-year EBIT growth. So we don’t think adesso’s use of debt is risky. Over time, share prices tend to follow earnings per share, so if you’re interested in adesso, you may well want to click here to check an interactive graph of its earnings per share history.
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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