Is ActivEX (ASX:AIV) Using Too Much Debt?

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 ActivEX Limited (ASX:AIV) makes use of debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for ActivEX

What Is ActivEX's Debt?

You can click the graphic below for the historical numbers, but it shows that ActivEX had AU$2.31m of debt in December 2022, down from AU$4.35m, one year before. However, it also had AU$1.82m in cash, and so its net debt is AU$481.0k.

How Healthy Is ActivEX's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that ActivEX had liabilities of AU$2.43m due within 12 months and no liabilities due beyond that. Offsetting this, it had AU$1.82m in cash and AU$600.0k in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

This state of affairs indicates that ActivEX's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the AU$5.83m company is short on cash, but still worth keeping an eye on the balance sheet.

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).

ActivEX's debt of just -0.86 times EBITDA is clearly modest. But strangely, EBIT was only 0.14 times interest expenses, suggesting the that may paint an overly pretty picture of the stock. We also note that ActivEX improved its EBIT from a last year's loss to a positive AU$59k. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since ActivEX 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, 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, ActivEX 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

Neither ActivEX's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But its net debt to EBITDA tells a very different story, and suggests some resilience. We think that ActivEX's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for ActivEX you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.