Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We can see that Australian Agricultural Company Limited (ASX:AAC) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Australian Agricultural's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Australian Agricultural had AU$377.1m of debt in March 2021, down from AU$396.3m, one year before. However, it does have AU$8.88m in cash offsetting this, leading to net debt of about AU$368.2m.
How Healthy Is Australian Agricultural's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Australian Agricultural had liabilities of AU$31.4m due within 12 months and liabilities of AU$509.5m due beyond that. Offsetting this, it had AU$8.88m in cash and AU$7.20m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$524.9m.
While this might seem like a lot, it is not so bad since Australian Agricultural has a market capitalization of AU$904.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Australian Agricultural'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.
Over 12 months, Australian Agricultural made a loss at the EBIT level, and saw its revenue drop to AU$266m, which is a fall of 21%. To be frank that doesn't bode well.
Not only did Australian Agricultural's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost a very considerable AU$147m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. On the bright side, we note that trailing twelve month EBIT is worse than the free cash flow of AU$9.0m and the profit of AU$45m. So if we focus on those metrics there seems to be a chance the company will manage its debt without much trouble. 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. For example, we've discovered 2 warning signs for Australian Agricultural (1 doesn't sit too well with us!) that you should be aware of before investing here.
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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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.
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