Is AB (WSE:ABE) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We note that AB S.A. (WSE:ABE) 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 is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for AB

What Is AB's Net Debt?

You can click the graphic below for the historical numbers, but it shows that AB had zł244.3m of debt in June 2020, down from zł319.3m, one year before. But on the other hand it also has zł277.8m in cash, leading to a zł33.5m net cash position.

A Look At AB's Liabilities

The latest balance sheet data shows that AB had liabilities of zł1.61b due within a year, and liabilities of zł156.6m falling due after that. On the other hand, it had cash of zł277.8m and zł1.08b worth of receivables due within a year. So it has liabilities totalling zł404.6m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of zł510.1m, so it does suggest shareholders should keep an eye on AB's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. While it does have liabilities worth noting, AB also has more cash than debt, so we're pretty confident it can manage its debt safely.

If AB can keep growing EBIT at last year's rate of 12% over the last year, then it will find its debt load easier to manage. 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 AB can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While AB 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. Happily for any shareholders, AB actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

Although AB's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of zł33.5m. And it impressed us with free cash flow of zł282m, being 147% of its EBIT. So we don't have any problem with AB's use of debt. 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. Case in point: We've spotted 1 warning sign for AB 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. 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.
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