Is a2 Milk (NZSE:ATM) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that The a2 Milk Company Limited (NZSE:ATM) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. 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.

See our latest analysis for a2 Milk

What Is a2 Milk's Debt?

You can click the graphic below for the historical numbers, but it shows that a2 Milk had NZ$82.0m of debt in June 2023, down from NZ$107.0m, one year before. But it also has NZ$802.2m in cash to offset that, meaning it has NZ$720.2m net cash.

How Healthy 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 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!

And we also note warmly that a2 Milk grew its EBIT by 13% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. 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. While a2 Milk has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, a2 Milk produced sturdy free cash flow equating to 76% 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 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 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.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.