Stock Analysis

Is ADF Group (TSE:DRX) A Risky Investment?

TSX:DRX
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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for ADF Group

What Is ADF Group's Net Debt?

As you can see below, ADF Group had CA$24.8m of debt at October 2020, down from CA$34.4m a year prior. However, it also had CA$18.8m in cash, and so its net debt is CA$6.01m.

debt-equity-history-analysis
TSX:DRX Debt to Equity History December 11th 2020

How Strong Is ADF Group's Balance Sheet?

We can see from the most recent balance sheet that ADF Group had liabilities of CA$51.1m falling due within a year, and liabilities of CA$30.2m due beyond that. Offsetting this, it had CA$18.8m in cash and CA$59.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$2.63m.

Since publicly traded ADF Group shares are worth a total of CA$50.6m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While ADF Group's low debt to EBITDA ratio of 0.47 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.2 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Notably, ADF Group made a loss at the EBIT level, last year, but improved that to positive EBIT of CA$9.3m in the last twelve months. 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 if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, ADF Group actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

The good news is that ADF Group's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Taking all this data into account, it seems to us that ADF Group takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that ADF Group is showing 2 warning signs in our investment analysis , 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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This article by Simply Wall St is general in nature. 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.
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