Acadian Timber (TSE:ADN) Takes On Some Risk With Its Use Of 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Acadian Timber Corp. (TSE:ADN) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Acadian Timber

What Is Acadian Timber's Net Debt?

As you can see below, Acadian Timber had CA$101.2m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CA$10.3m in cash leading to net debt of about CA$90.9m.

How Healthy Is Acadian Timber's Balance Sheet?

We can see from the most recent balance sheet that Acadian Timber had liabilities of CA$13.5m falling due within a year, and liabilities of CA$206.7m due beyond that. Offsetting this, it had CA$10.3m in cash and CA$8.15m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$201.8m.

This is a mountain of leverage relative to its market capitalization of CA$301.7m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Acadian Timber has a debt to EBITDA ratio of 4.3 and its EBIT covered its interest expense 4.8 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Acadian Timber saw its EBIT slide 6.3% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Acadian Timber's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Acadian Timber recorded free cash flow worth 50% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Mulling over Acadian Timber's attempt at managing its debt, based on its EBITDA,, we're certainly not enthusiastic. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. Once we consider all the factors above, together, it seems to us that Acadian Timber'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. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Acadian Timber (of which 1 is a bit unpleasant!) 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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