Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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. As with many other companies Apiam Animal Health Limited (ASX:AHX) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Apiam Animal Health Carry?
The image below, which you can click on for greater detail, shows that at June 2020 Apiam Animal Health had debt of AU$37.0m, up from AU$25.1m in one year. However, it does have AU$2.51m in cash offsetting this, leading to net debt of about AU$34.5m.
How Strong Is Apiam Animal Health’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Apiam Animal Health had liabilities of AU$26.2m due within 12 months and liabilities of AU$46.3m due beyond that. Offsetting these obligations, it had cash of AU$2.51m as well as receivables valued at AU$12.1m due within 12 months. So its liabilities total AU$57.9m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of AU$60.6m, so it does suggest shareholders should keep an eye on Apiam Animal Health’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Apiam Animal Health’s debt is 3.1 times its EBITDA, and its EBIT cover its interest expense 5.7 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Also relevant is that Apiam Animal Health has grown its EBIT by a very respectable 28% in the last year, thus enhancing its ability to pay down 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 Apiam Animal Health’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Apiam Animal Health recorded free cash flow worth 59% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On our analysis Apiam Animal Health’s EBIT growth rate should signal that it won’t have too much trouble with its debt. However, our other observations weren’t so heartening. For instance it seems like it has to struggle a bit to handle its total liabilities. We would also note that Healthcare industry companies like Apiam Animal Health commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Apiam Animal Health’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we’ve spotted 4 warning signs for Apiam Animal Health you should know about.
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.
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