A.D.Works GroupLtd (TSE:2982) Has A Somewhat Strained Balance Sheet

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.' 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 A.D.Works Group Co.,Ltd. (TSE:2982) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for A.D.Works GroupLtd

How Much Debt Does A.D.Works GroupLtd Carry?

The image below, which you can click on for greater detail, shows that at December 2023 A.D.Works GroupLtd had debt of JP¥34.8b, up from JP¥32.5b in one year. However, it does have JP¥9.81b in cash offsetting this, leading to net debt of about JP¥25.0b.

A Look At A.D.Works GroupLtd's Liabilities

Zooming in on the latest balance sheet data, we can see that A.D.Works GroupLtd had liabilities of JP¥15.0b due within 12 months and liabilities of JP¥26.6b due beyond that. Offsetting this, it had JP¥9.81b in cash and JP¥116.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by JP¥31.8b.

The deficiency here weighs heavily on the JP¥11.4b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, A.D.Works GroupLtd would probably need a major re-capitalization if its creditors were to demand repayment.

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

A.D.Works GroupLtd has a rather high debt to EBITDA ratio of 9.7 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 5.2 times, suggesting it can responsibly service its obligations. Importantly, A.D.Works GroupLtd grew its EBIT by 78% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is A.D.Works GroupLtd's earnings that will influence how the balance sheet holds up in the future. 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 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. Over the last three years, A.D.Works GroupLtd saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, A.D.Works GroupLtd's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that A.D.Works GroupLtd's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for A.D.Works GroupLtd (of which 1 shouldn't be ignored!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.