Ag Growth International (TSE:AFN) Takes On Some Risk With Its Use Of 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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Ag Growth International Inc. (TSE:AFN) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Ag Growth International

What Is Ag Growth International's Debt?

As you can see below, Ag Growth International had CA$903.7m of debt at June 2023, down from CA$978.5m a year prior. However, because it has a cash reserve of CA$70.7m, its net debt is less, at about CA$833.1m.

How Strong Is Ag Growth International's Balance Sheet?

We can see from the most recent balance sheet that Ag Growth International had liabilities of CA$483.9m falling due within a year, and liabilities of CA$908.7m due beyond that. Offsetting these obligations, it had cash of CA$70.7m as well as receivables valued at CA$304.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$1.02b.

Given this deficit is actually higher than the company's market capitalization of CA$979.5m, we think shareholders really should watch Ag Growth International's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Ag Growth International's debt to EBITDA ratio (4.3) suggests that it uses some debt, its interest cover is very weak, at 2.1, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The good news is that Ag Growth International grew its EBIT a smooth 70% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Ag Growth International 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. Looking at the most recent three years, Ag Growth International recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Ag Growth International's net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Ag Growth International stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Case in point: We've spotted 1 warning sign for Ag Growth International you should be aware of.

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.

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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.