We Think Avio (BIT:AVIO) Is Taking Some Risk With Its Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Avio S.p.A. (BIT:AVIO) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

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What Is Avio's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Avio had €29.8m of debt in June 2022, down from €44.8m, one year before. But it also has €77.1m in cash to offset that, meaning it has €47.3m net cash.

How Strong Is Avio's Balance Sheet?

We can see from the most recent balance sheet that Avio had liabilities of €718.9m falling due within a year, and liabilities of €164.6m due beyond that. Offsetting this, it had €77.1m in cash and €425.5m in receivables that were due within 12 months. So it has liabilities totalling €381.0m more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's €255.6m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Given that Avio has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

But the other side of the story is that Avio saw its EBIT decline by 6.0% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Avio 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 company can only pay off debt with cold hard cash, not accounting profits. While Avio has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Avio actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While Avio does have more liabilities than liquid assets, it also has net cash of €47.3m. The cherry on top was that in converted 181% of that EBIT to free cash flow, bringing in €19m. So although we see some areas for improvement, we're not too worried about Avio's balance sheet. 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 Avio is showing 2 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.