Does Australian Agricultural Projects (ASX:AAP) Have A Healthy Balance Sheet?

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.' 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 Australian Agricultural Projects Ltd (ASX:AAP) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Australian Agricultural Projects

How Much Debt Does Australian Agricultural Projects Carry?

As you can see below, at the end of December 2021, Australian Agricultural Projects had AU$6.69m of debt, up from AU$2.06m a year ago. Click the image for more detail. However, it also had AU$729.8k in cash, and so its net debt is AU$5.96m.

A Look At Australian Agricultural Projects' Liabilities

Zooming in on the latest balance sheet data, we can see that Australian Agricultural Projects had liabilities of AU$8.18m due within 12 months and liabilities of AU$1.47m due beyond that. On the other hand, it had cash of AU$729.8k and AU$2.20m worth of receivables due within a year. So its liabilities total AU$6.72m more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of AU$6.71m, we think shareholders really should watch Australian Agricultural Projects's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Australian Agricultural Projects shareholders face the double whammy of a high net debt to EBITDA ratio (5.2), and fairly weak interest coverage, since EBIT is just 0.92 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that Australian Agricultural Projects achieved a positive EBIT of AU$632k in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Australian Agricultural Projects will need earnings to service that debt. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Australian Agricultural Projects burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Australian Agricultural Projects's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. We're quite clear that we consider Australian Agricultural Projects to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Australian Agricultural Projects has 5 warning signs (and 3 which shouldn't be ignored) we think 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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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.