ADF Group (TSE:DRX) Could Easily Take On More 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 ADF Group Inc. (TSE:DRX) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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 ADF Group

What Is ADF Group's Debt?

As you can see below, ADF Group had CA$18.8m of debt at October 2021, down from CA$24.8m a year prior. However, because it has a cash reserve of CA$14.7m, its net debt is less, at about CA$4.11m.

How Strong Is ADF Group's Balance Sheet?

According to the last reported balance sheet, ADF Group had liabilities of CA$77.8m due within 12 months, and liabilities of CA$26.2m due beyond 12 months. Offsetting this, it had CA$14.7m in cash and CA$83.5m in receivables that were due within 12 months. So its liabilities total CA$5.82m more than the combination of its cash and short-term receivables.

Given ADF Group has a market capitalization of CA$57.1m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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

ADF Group's net debt is only 0.29 times its EBITDA. And its EBIT covers its interest expense a whopping 10.4 times over. So we're pretty relaxed about its super-conservative use of debt. Also good is that ADF Group grew its EBIT at 16% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since ADF Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, ADF Group actually produced more free cash flow than EBIT over the last two years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Happily, ADF Group's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Overall, we don't think ADF Group is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for ADF Group that you should be aware of before investing here.

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.