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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Art's-Way Manufacturing Co., Inc. (NASDAQ:ARTW) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Art's-Way Manufacturing's Net Debt?
As you can see below, Art's-Way Manufacturing had US$5.17m of debt, at November 2020, which is about the same as the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn't have much cash.
A Look At Art's-Way Manufacturing's Liabilities
The latest balance sheet data shows that Art's-Way Manufacturing had liabilities of US$6.16m due within a year, and liabilities of US$2.73m falling due after that. Offsetting these obligations, it had cash of US$2.7k as well as receivables valued at US$2.47m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$6.42m.
While this might seem like a lot, it is not so bad since Art's-Way Manufacturing has a market capitalization of US$15.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Art's-Way Manufacturing will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
In the last year Art's-Way Manufacturing had a loss before interest and tax, and actually shrunk its revenue by 2.1%, to US$22m. That's not what we would hope to see.
Over the last twelve months Art's-Way Manufacturing produced an earnings before interest and tax (EBIT) loss. Indeed, it lost a very considerable US$3.9m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled US$1.5m in negative free cash flow over the last twelve months. So suffice it to say we consider the stock very risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 5 warning signs for Art's-Way Manufacturing you should be aware of, and 2 of them don't sit too well with us.
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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What are the risks and opportunities for Art's-Way Manufacturing?
Became profitable this year
Interest payments are not well covered by earnings
Does not have a meaningful market cap ($12M)
Shareholders have been diluted in the past year
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Art's-Way Manufacturing Co., Inc. manufactures and sells agricultural equipment, specialized modular science buildings, and steel cutting tools in the United States and internationally.
Acceptable track record with imperfect balance sheet.