We Think a2 Milk (NZSE:ATM) Can Stay On Top Of Its Debt

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.' 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 note that The a2 Milk Company Limited (NZSE:ATM) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for a2 Milk

What Is a2 Milk's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 a2 Milk had NZ$80.0m of debt, an increase on none, over one year. But it also has NZ$747.2m in cash to offset that, meaning it has NZ$667.2m net cash.

How Healthy Is a2 Milk's Balance Sheet?

We can see from the most recent balance sheet that a2 Milk had liabilities of NZ$387.4m falling due within a year, and liabilities of NZ$78.4m due beyond that. On the other hand, it had cash of NZ$747.2m and NZ$120.5m worth of receivables due within a year. So it actually has NZ$401.9m 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. Succinctly put, a2 Milk boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that a2 Milk's load is not too heavy, because its EBIT was down 91% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. 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 generated free cash flow amounting to a very robust 80% 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$667.2m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of NZ$195m, being 80% of its EBIT. So we are not troubled with a2 Milk's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for a2 Milk you should be aware of.

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.