Adastria (TSE:2685) Could Easily Take On More 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.' 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. Importantly, Adastria Co., Ltd. (TSE:2685) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Adastria

What Is Adastria's Debt?

The image below, which you can click on for greater detail, shows that Adastria had debt of JP¥1.22b at the end of May 2024, a reduction from JP¥3.19b over a year. However, it does have JP¥20.2b in cash offsetting this, leading to net cash of JP¥18.9b.

How Strong Is Adastria's Balance Sheet?

We can see from the most recent balance sheet that Adastria had liabilities of JP¥48.8b falling due within a year, and liabilities of JP¥8.09b due beyond that. Offsetting these obligations, it had cash of JP¥20.2b as well as receivables valued at JP¥20.0b due within 12 months. So it has liabilities totalling JP¥16.8b more than its cash and near-term receivables, combined.

Given Adastria has a market capitalization of JP¥153.2b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Adastria also has more cash than debt, so we're pretty confident it can manage its debt safely.

In addition to that, we're happy to report that Adastria has boosted its EBIT by 34%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Adastria 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Adastria 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. Over the most recent three years, Adastria recorded free cash flow worth 52% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

Although Adastria's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of JP¥18.9b. And we liked the look of last year's 34% year-on-year EBIT growth. So is Adastria's debt a risk? It doesn't seem so to us. 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. For example, we've discovered 1 warning sign for Adastria that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.