a2 Milk (NZSE:ATM) Could Easily Take On More Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, The a2 Milk Company Limited (NZSE:ATM) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for a2 Milk

How Much Debt Does a2 Milk Carry?

As you can see below, a2 Milk had NZ$82.0m of debt at June 2023, down from NZ$107.0m a year prior. However, it does have NZ$802.2m in cash offsetting this, leading to net cash of NZ$720.2m.

How Strong Is a2 Milk's Balance Sheet?

According to the last reported balance sheet, a2 Milk had liabilities of NZ$379.2m due within 12 months, and liabilities of NZ$83.0m due beyond 12 months. Offsetting these obligations, it had cash of NZ$802.2m as well as receivables valued at NZ$79.2m due within 12 months. So it can boast NZ$419.2m more liquid assets than total liabilities.

This surplus suggests that a2 Milk has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, a2 Milk boasts net cash, so it's fair to say it does not have a heavy debt load!

And we also note warmly that a2 Milk grew its EBIT by 13% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine a2 Milk's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. a2 Milk 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, a2 Milk recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to investigate a company's debt, in this case a2 Milk has NZ$720.2m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 76% of that EBIT to free cash flow, bringing in NZ$101m. So is a2 Milk's debt a risk? It doesn't seem so to us. Over time, share prices tend to follow earnings per share, so if you're interested in a2 Milk, you may well want to click here to check an interactive graph of its earnings per share history.

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.