Does Art's-Way Manufacturing (NASDAQ:ARTW) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Art's-Way Manufacturing

How Much Debt Does Art's-Way Manufacturing Carry?

As you can see below, Art's-Way Manufacturing had US$7.66m of debt, at May 2023, which is about the same as the year before. You can click the chart for greater detail. And it doesn't have much cash, so its net debt is about the same.

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$9.89m due within 12 months, and liabilities of US$3.71m due beyond 12 months. Offsetting this, it had US$2.3k in cash and US$4.26m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$9.34m.

This deficit is considerable relative to its market capitalization of US$11.5m, so it does suggest shareholders should keep an eye on Art's-Way Manufacturing's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

While we wouldn't worry about Art's-Way Manufacturing's net debt to EBITDA ratio of 3.2, we think its super-low interest cover of 2.5 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, it should be some comfort for shareholders to recall that Art's-Way Manufacturing actually grew its EBIT by a hefty 126%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last two years, Art's-Way Manufacturing burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Art's-Way Manufacturing's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Art's-Way Manufacturing stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Art's-Way Manufacturing (of which 1 is a bit concerning!) you should know about.

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.