Is Adbri (ASX:ABC) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Adbri Limited (ASX:ABC) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Adbri

What Is Adbri's Net Debt?

As you can see below, Adbri had AU$466.1m of debt at December 2020, down from AU$540.1m a year prior. However, it also had AU$94.0m in cash, and so its net debt is AU$372.1m.

A Look At Adbri's Liabilities

According to the last reported balance sheet, Adbri had liabilities of AU$221.3m due within 12 months, and liabilities of AU$679.6m due beyond 12 months. Offsetting this, it had AU$94.0m in cash and AU$196.8m in receivables that were due within 12 months. So its liabilities total AU$610.1m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Adbri has a market capitalization of AU$2.17b, 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.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Adbri's net debt is sitting at a very reasonable 1.7 times its EBITDA, while its EBIT covered its interest expense just 6.9 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Also good is that Adbri grew its EBIT at 18% over the last year, further increasing its ability to manage debt. 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 Adbri's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Adbri produced sturdy free cash flow equating to 75% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Adbri's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Taking all this data into account, it seems to us that Adbri takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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 be aware of the 1 warning sign we've spotted with Adbri .

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. 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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