Is A2B Australia (ASX:A2B) 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. Importantly, A2B Australia Limited (ASX:A2B) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for A2B Australia

What Is A2B Australia's Debt?

The image below, which you can click on for greater detail, shows that A2B Australia had debt of AU$15.6m at the end of June 2023, a reduction from AU$18.9m over a year. However, it does have AU$29.5m in cash offsetting this, leading to net cash of AU$13.9m.

A Look At A2B Australia's Liabilities

According to the last reported balance sheet, A2B Australia had liabilities of AU$50.8m due within 12 months, and liabilities of AU$19.8m due beyond 12 months. Offsetting these obligations, it had cash of AU$29.5m as well as receivables valued at AU$45.8m due within 12 months. So it actually has AU$4.69m more liquid assets than total liabilities.

This surplus suggests that A2B Australia has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that A2B Australia has more cash than debt is arguably a good indication that it can manage its debt safely.

Notably, A2B Australia made a loss at the EBIT level, last year, but improved that to positive EBIT of AU$10m in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if A2B Australia can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While A2B Australia has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last year, A2B Australia reported free cash flow worth 2.2% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case A2B Australia has AU$13.9m in net cash and a decent-looking balance sheet. So we are not troubled with A2B Australia's debt use. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that A2B Australia is showing 3 warning signs in our investment analysis , and 2 of those are a bit unpleasant...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.