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 can see that Adbri Limited (ASX:ABC) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Adbri

What Is Adbri's Net Debt?

As you can see below, at the end of June 2023, Adbri had AU$778.1m of debt, up from AU$631.1m a year ago. Click the image for more detail. However, because it has a cash reserve of AU$105.2m, its net debt is less, at about AU$672.9m.

How Healthy Is Adbri's Balance Sheet?

The latest balance sheet data shows that Adbri had liabilities of AU$266.7m due within a year, and liabilities of AU$1.03b falling due after that. Offsetting this, it had AU$105.2m in cash and AU$299.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$892.7m.

This deficit isn't so bad because Adbri is worth AU$1.53b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Adbri's debt is 3.1 times its EBITDA, and its EBIT cover its interest expense 4.4 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. More concerning, Adbri saw its EBIT drop by 2.0% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Adbri can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Adbri actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Mulling over Adbri's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its EBIT growth rate is not so bad. Looking at the bigger picture, it seems clear to us that Adbri's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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 2 warning signs for Adbri 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.