Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Amsterdam Commodities N.V. (AMS:ACOMO) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Amsterdam Commodities Carry?
The image below, which you can click on for greater detail, shows that at December 2020 Amsterdam Commodities had debt of €277.1m, up from €69.0m in one year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Amsterdam Commodities' Balance Sheet?
We can see from the most recent balance sheet that Amsterdam Commodities had liabilities of €248.5m falling due within a year, and liabilities of €166.4m due beyond that. Offsetting this, it had €3.51m in cash and €139.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €272.5m.
This deficit isn't so bad because Amsterdam Commodities is worth €660.0m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Strangely Amsterdam Commodities has a sky high EBITDA ratio of 5.4, implying high debt, but a strong interest coverage of 16.6. So either it has access to very cheap long term debt or that interest expense is going to grow! Sadly, Amsterdam Commodities's EBIT actually dropped 7.5% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Amsterdam Commodities's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Amsterdam Commodities produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
On our analysis Amsterdam Commodities's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, net debt to EBITDA gives us cold feet. Looking at all this data makes us feel a little cautious about Amsterdam Commodities's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Case in point: We've spotted 3 warning signs for Amsterdam Commodities you should be aware of, and 2 of them are concerning.
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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