a2 Milk (NZSE:ATM) Seems To Use Debt Rather Sparingly

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.' 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, The a2 Milk Company Limited (NZSE:ATM) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for a2 Milk

What Is a2 Milk's Debt?

The image below, which you can click on for greater detail, shows that at December 2022 a2 Milk had debt of NZ$106.2m, up from NZ$80.0m in one year. However, it does have NZ$777.2m in cash offsetting this, leading to net cash of NZ$671.0m.

A Look At a2 Milk's Liabilities

Zooming in on the latest balance sheet data, we can see that a2 Milk had liabilities of NZ$414.8m due within 12 months and liabilities of NZ$79.6m due beyond that. Offsetting this, it had NZ$777.2m in cash and NZ$78.7m in receivables that were due within 12 months. So it can boast NZ$361.5m more liquid assets than total liabilities.

This short term liquidity is a sign that a2 Milk could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, a2 Milk boasts net cash, so it's fair to say it does not have a heavy debt load!

Even more impressive was the fact that a2 Milk grew its EBIT by 362% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if a2 Milk 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 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. During the last three years, a2 Milk produced sturdy free cash flow equating to 78% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that a2 Milk has net cash of NZ$671.0m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 362% over the last year. So we don't think a2 Milk's use of debt is risky. Another factor that would give us confidence in a2 Milk would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.

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.