Allied Digital Services (NSE:ADSL) Seems To Use Debt Quite Sensibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Allied Digital Services Limited (NSE:ADSL) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Allied Digital Services

What Is Allied Digital Services's Debt?

The image below, which you can click on for greater detail, shows that at March 2021 Allied Digital Services had debt of ₹540.1m, up from ₹516.9m in one year. But on the other hand it also has ₹1.12b in cash, leading to a ₹576.8m net cash position.

How Strong Is Allied Digital Services' Balance Sheet?

The latest balance sheet data shows that Allied Digital Services had liabilities of ₹1.26b due within a year, and liabilities of ₹304.4m falling due after that. Offsetting these obligations, it had cash of ₹1.12b as well as receivables valued at ₹1.66b due within 12 months. So it actually has ₹1.21b more liquid assets than total liabilities.

This luscious liquidity implies that Allied Digital Services' balance sheet is sturdy like a giant sequoia tree. With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Succinctly put, Allied Digital Services boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, Allied Digital Services's EBIT dived 14%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Allied Digital Services's earnings that will influence how the balance sheet holds up in the future. 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. Allied Digital Services may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, Allied Digital Services actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Allied Digital Services has net cash of ₹576.8m, as well as more liquid assets than liabilities. The cherry on top was that in converted 110% of that EBIT to free cash flow, bringing in ₹351m. So we don't think Allied Digital Services's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Allied Digital Services , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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