A.D.Works GroupLtd (TSE:2982) Takes On Some Risk With Its Use Of Debt

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. We note that A.D.Works Group Co.,Ltd. (TSE:2982) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

What Is A.D.Works GroupLtd's Debt?

The chart below, which you can click on for greater detail, shows that A.D.Works GroupLtd had JP¥35.7b in debt in December 2024; about the same as the year before. However, it also had JP¥10.1b in cash, and so its net debt is JP¥25.5b.

How Healthy Is A.D.Works GroupLtd's Balance Sheet?

We can see from the most recent balance sheet that A.D.Works GroupLtd had liabilities of JP¥10.1b falling due within a year, and liabilities of JP¥30.9b due beyond that. Offsetting these obligations, it had cash of JP¥10.1b as well as receivables valued at JP¥109.0m due within 12 months. So it has liabilities totalling JP¥30.8b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the JP¥10.9b 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'd watch its balance sheet closely, without a doubt. At the end of the day, A.D.Works GroupLtd would probably need a major re-capitalization if its creditors were to demand repayment.

View our latest analysis for A.D.Works GroupLtd

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With a net debt to EBITDA ratio of 7.5, it's fair to say A.D.Works GroupLtd does have a significant amount of debt. However, its interest coverage of 5.7 is reasonably strong, which is a good sign. Importantly, A.D.Works GroupLtd grew its EBIT by 32% 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot .

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, A.D.Works GroupLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both A.D.Works GroupLtd's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that A.D.Works GroupLtd's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for A.D.Works GroupLtd (1 is potentially serious) you should be aware of.

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.