We Think Atlas Engineered Products (CVE:AEP) Is Taking Some Risk With Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 Atlas Engineered Products Ltd. (CVE:AEP) makes use of debt. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Atlas Engineered Products

What Is Atlas Engineered Products's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Atlas Engineered Products had debt of CA$34.5m, up from CA$13.9m in one year. However, it does have CA$15.0m in cash offsetting this, leading to net debt of about CA$19.5m.

How Strong Is Atlas Engineered Products' Balance Sheet?

The latest balance sheet data shows that Atlas Engineered Products had liabilities of CA$9.75m due within a year, and liabilities of CA$37.7m falling due after that. Offsetting these obligations, it had cash of CA$15.0m as well as receivables valued at CA$10.1m due within 12 months. So its liabilities total CA$22.4m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Atlas Engineered Products has a market capitalization of CA$88.6m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Atlas Engineered Products's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 6.5 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, Atlas Engineered Products's EBIT fell a jaw-dropping 47% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Atlas Engineered Products 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. During the last three years, Atlas Engineered Products produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Atlas Engineered Products's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its conversion of EBIT to free cash flow was re-invigorating. We think that Atlas Engineered Products's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. 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 4 warning signs for Atlas Engineered Products 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. 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.