Alfabs Australia (ASX:AAL) Seems To Use Debt Quite Sensibly

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.' 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, Alfabs Australia Limited (ASX:AAL) does carry debt. But the more important question is: how much risk is that debt creating?

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What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Alfabs Australia Carry?

As you can see below, Alfabs Australia had AU$16.7m of debt at December 2024, down from AU$19.4m a year prior. However, because it has a cash reserve of AU$5.65m, its net debt is less, at about AU$11.0m.

How Healthy Is Alfabs Australia's Balance Sheet?

According to the last reported balance sheet, Alfabs Australia had liabilities of AU$37.5m due within 12 months, and liabilities of AU$15.3m due beyond 12 months. Offsetting these obligations, it had cash of AU$5.65m as well as receivables valued at AU$16.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$31.0m.

While this might seem like a lot, it is not so bad since Alfabs Australia has a market capitalization of AU$101.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

See our latest analysis for Alfabs Australia

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Alfabs Australia's net debt is only 0.54 times its EBITDA. And its EBIT covers its interest expense a whopping 11.3 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, Alfabs Australia grew its EBIT by 36% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Alfabs Australia 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last two years, Alfabs Australia burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Alfabs Australia's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to grow its EBIT is pretty flash. When we consider all the elements mentioned above, it seems to us that Alfabs Australia is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 4 warning signs we've spotted with Alfabs Australia (including 1 which is a bit unpleasant) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.