Here's Why Allied Digital Services (NSE:ADSL) Can Manage Its Debt Responsibly

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Allied Digital Services Limited (NSE:ADSL) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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. 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 Allied Digital Services

What Is Allied Digital Services's Net Debt?

The image below, which you can click on for greater detail, shows that Allied Digital Services had debt of ₹434.5m at the end of September 2023, a reduction from ₹476.8m over a year. However, it does have ₹993.2m in cash offsetting this, leading to net cash of ₹558.7m.

How Strong Is Allied Digital Services' Balance Sheet?

The latest balance sheet data shows that Allied Digital Services had liabilities of ₹1.14b due within a year, and liabilities of ₹123.0m falling due after that. On the other hand, it had cash of ₹993.2m and ₹1.36b worth of receivables due within a year. So it actually has ₹1.09b more liquid assets than total liabilities.

This short term liquidity is a sign that Allied Digital Services could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Allied Digital Services has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Allied Digital Services's saving grace is its low debt levels, because its EBIT has tanked 29% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Allied Digital Services 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. 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. In the last three years, Allied Digital Services's free cash flow amounted to 47% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Allied Digital Services has net cash of ₹558.7m, as well as more liquid assets than liabilities. So we don't have any problem with Allied Digital Services's use of debt. 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. Be aware that Allied Digital Services is showing 3 warning signs in our investment analysis , you should know about...

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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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.