Is a2 Milk (NZSE:ATM) Using Too Much Debt?

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 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. We can see that The a2 Milk Company Limited (NZSE:ATM) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

Check out our latest analysis for a2 Milk

What Is a2 Milk's Net Debt?

As you can see below, a2 Milk had NZ$37.9m of debt at June 2024, down from NZ$82.0m a year prior. But on the other hand it also has NZ$968.9m in cash, leading to a NZ$931.1m net cash position.

How Healthy Is a2 Milk's Balance Sheet?

The latest balance sheet data shows that a2 Milk had liabilities of NZ$416.8m due within a year, and liabilities of NZ$61.3m falling due after that. On the other hand, it had cash of NZ$968.9m and NZ$78.1m worth of receivables due within a year. So it can boast NZ$568.9m 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. Simply put, the fact that a2 Milk has more cash than debt is arguably a good indication that it can manage its debt safely.

a2 Milk's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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 generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case a2 Milk has NZ$931.1m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 92% of that EBIT to free cash flow, bringing in NZ$235m. So is a2 Milk's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for a2 Milk that you should be aware of.

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.