Here's Why Australian Agricultural Projects (ASX:AAP) Has A Meaningful Debt Burden

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Australian Agricultural Projects Ltd (ASX:AAP) does carry debt. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for Australian Agricultural Projects

How Much Debt Does Australian Agricultural Projects Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Australian Agricultural Projects had AU$6.95m of debt, an increase on AU$5.13m, over one year. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is Australian Agricultural Projects' Balance Sheet?

According to the last reported balance sheet, Australian Agricultural Projects had liabilities of AU$2.99m due within 12 months, and liabilities of AU$6.68m due beyond 12 months. Offsetting this, it had AU$134.9k in cash and AU$3.05m in receivables that were due within 12 months. So it has liabilities totalling AU$6.48m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of AU$9.76m, so it does suggest shareholders should keep an eye on Australian Agricultural Projects' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.7 times and a disturbingly high net debt to EBITDA ratio of 5.0 hit our confidence in Australian Agricultural Projects like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for Australian Agricultural Projects is that it turned last year's EBIT loss into a gain of AU$928k, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Australian Agricultural Projects will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Australian Agricultural Projects 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

To be frank both Australian Agricultural Projects's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. We're quite clear that we consider Australian Agricultural Projects to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Case in point: We've spotted 5 warning signs for Australian Agricultural Projects you should be aware of, and 2 of them can't be ignored.

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.
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