Art's-Way Manufacturing (NASDAQ:ARTW) Use Of Debt Could Be Considered Risky

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Art's-Way Manufacturing Co., Inc. (NASDAQ:ARTW) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Art's-Way Manufacturing

What Is Art's-Way Manufacturing's Debt?

As you can see below, at the end of May 2022, Art's-Way Manufacturing had US$7.75m of debt, up from US$6.86m a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Art's-Way Manufacturing's Balance Sheet?

According to the last reported balance sheet, Art's-Way Manufacturing had liabilities of US$10.4m due within 12 months, and liabilities of US$3.38m due beyond 12 months. Offsetting these obligations, it had cash of US$5.0k as well as receivables valued at US$3.00m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$10.7m.

When you consider that this deficiency exceeds the company's US$9.65m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Art's-Way Manufacturing shareholders face the double whammy of a high net debt to EBITDA ratio (6.0), and fairly weak interest coverage, since EBIT is just 1.8 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Art's-Way Manufacturing is that it turned last year's EBIT loss into a gain of US$627k, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Art's-Way Manufacturing will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Art's-Way Manufacturing saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Art's-Way Manufacturing's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Art's-Way Manufacturing has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. We've identified 3 warning signs with Art's-Way Manufacturing (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.

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.