Health Check: How Prudently Does ADX Energy (ASX:ADX) Use Debt?

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. We note that ADX Energy Ltd (ASX:ADX) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for ADX Energy

What Is ADX Energy's Debt?

The image below, which you can click on for greater detail, shows that ADX Energy had debt of AU$4.39m at the end of December 2021, a reduction from AU$4.85m over a year. But on the other hand it also has AU$5.94m in cash, leading to a AU$1.55m net cash position.

A Look At ADX Energy's Liabilities

The latest balance sheet data shows that ADX Energy had liabilities of AU$8.54m due within a year, and liabilities of AU$15.9m falling due after that. Offsetting this, it had AU$5.94m in cash and AU$2.56m in receivables that were due within 12 months. So its liabilities total AU$16.0m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of AU$21.4m, so it does suggest shareholders should keep an eye on ADX Energy's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, ADX Energy boasts net cash, so it's fair to say it does not have a heavy debt load! The balance sheet is clearly the area to focus on when you are analysing debt. But it is ADX Energy's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

In the last year ADX Energy wasn't profitable at an EBIT level, but managed to grow its revenue by 41%, to AU$9.6m. Shareholders probably have their fingers crossed that it can grow its way to profits.

So How Risky Is ADX Energy?

Statistically speaking companies that lose money are riskier than those that make money. And the fact is that over the last twelve months ADX Energy lost money at the earnings before interest and tax (EBIT) line. And over the same period it saw negative free cash outflow of AU$3.1m and booked a AU$4.2m accounting loss. Given it only has net cash of AU$1.55m, the company may need to raise more capital if it doesn't reach break-even soon. With very solid revenue growth in the last year, ADX Energy may be on a path to profitability. Pre-profit companies are often risky, but they can also offer great rewards. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for ADX Energy (of which 1 shouldn't be ignored!) you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.