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. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, AMG Advanced Metallurgical Group N.V. (AMS:AMG) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does AMG Advanced Metallurgical Group Carry?
The image below, which you can click on for greater detail, shows that at September 2019 AMG Advanced Metallurgical Group had debt of US$699.4m, up from US$382.1m in one year. However, it also had US$229.0m in cash, and so its net debt is US$470.3m.
How Healthy Is AMG Advanced Metallurgical Group’s Balance Sheet?
The latest balance sheet data shows that AMG Advanced Metallurgical Group had liabilities of US$369.9m due within a year, and liabilities of US$897.9m falling due after that. Offsetting these obligations, it had cash of US$229.0m as well as receivables valued at US$156.1m due within 12 months. So it has liabilities totalling US$882.7m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company’s market capitalization of US$687.5m, we think shareholders really should watch AMG Advanced Metallurgical Group’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
AMG Advanced Metallurgical Group shareholders face the double whammy of a high net debt to EBITDA ratio (6.6), and fairly weak interest coverage, since EBIT is just 1.3 times the interest expense. This means we’d consider it to have a heavy debt load. Even worse, AMG Advanced Metallurgical Group saw its EBIT tank 77% over the last 12 months. 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 AMG Advanced Metallurgical Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, AMG Advanced Metallurgical Group actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
To be frank both AMG Advanced Metallurgical Group’s interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its conversion of EBIT to free cash flow fails to inspire much confidence. We think the chances that AMG Advanced Metallurgical Group has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Be aware that AMG Advanced Metallurgical Group is showing 2 warning signs in our investment analysis , and 1 of those doesn’t sit too well with us…
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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