Is Ag Growth International (TSE:AFN) 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Ag Growth International Inc. (TSE:AFN) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

View our latest analysis for Ag Growth International

What Is Ag Growth International's Net Debt?

The chart below, which you can click on for greater detail, shows that Ag Growth International had CA$865.3m in debt in December 2023; about the same as the year before. However, it also had CA$88.0m in cash, and so its net debt is CA$777.2m.

How Strong Is Ag Growth International's Balance Sheet?

The latest balance sheet data shows that Ag Growth International had liabilities of CA$548.0m due within a year, and liabilities of CA$789.0m falling due after that. Offsetting this, it had CA$88.0m in cash and CA$282.6m in receivables that were due within 12 months. So its liabilities total CA$966.3m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CA$1.15b, so it does suggest shareholders should keep an eye on Ag Growth International's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

While Ag Growth International's debt to EBITDA ratio (3.7) suggests that it uses some debt, its interest cover is very weak, at 2.1, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. On a slightly more positive note, Ag Growth International grew its EBIT at 17% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Ag Growth International 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. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Ag Growth International's free cash flow amounted to 26% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Ag Growth International's attempt at covering its interest expense with its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Ag Growth International's debt is making it 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. 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. For example, we've discovered 1 warning sign for Ag Growth International that you should be aware of before investing here.

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. 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.