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, AoFrio Limited (NZSE:AOF) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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 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 think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for AoFrio
What Is AoFrio's Debt?
As you can see below, at the end of December 2023, AoFrio had NZ$4.99m of debt, up from NZ$3.84m a year ago. Click the image for more detail. On the flip side, it has NZ$3.30m in cash leading to net debt of about NZ$1.69m.
How Healthy Is AoFrio's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that AoFrio had liabilities of NZ$24.5m due within 12 months and liabilities of NZ$14.5m due beyond that. Offsetting this, it had NZ$3.30m in cash and NZ$16.2m in receivables that were due within 12 months. So it has liabilities totalling NZ$19.5m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of NZ$25.0m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. When analysing debt levels, the balance sheet is the obvious place to start. But it is AoFrio'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.
In the last year AoFrio had a loss before interest and tax, and actually shrunk its revenue by 10%, to NZ$67m. That's not what we would hope to see.
Caveat Emptor
While AoFrio's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Its EBIT loss was a whopping NZ$2.9m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. However, it doesn't help that it burned through NZ$431k of cash over the last year. So to be blunt we think it is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for AoFrio (of which 1 is concerning!) you should know about.
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.
About NZSE:AOF
Flawless balance sheet and good value.
