Does Advanced Drainage Systems (NYSE:WMS) Have A Healthy Balance Sheet?

By
Simply Wall St
Published
March 18, 2022
NYSE:WMS
Source: Shutterstock

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.' 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. We note that Advanced Drainage Systems, Inc. (NYSE:WMS) 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?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Advanced Drainage Systems

How Much Debt Does Advanced Drainage Systems Carry?

The image below, which you can click on for greater detail, shows that at December 2021 Advanced Drainage Systems had debt of US$952.5m, up from US$790.9m in one year. On the flip side, it has US$22.2m in cash leading to net debt of about US$930.4m.

debt-equity-history-analysis
NYSE:WMS Debt to Equity History March 18th 2022

How Healthy Is Advanced Drainage Systems' Balance Sheet?

According to the last reported balance sheet, Advanced Drainage Systems had liabilities of US$364.1m due within 12 months, and liabilities of US$1.17b due beyond 12 months. Offsetting these obligations, it had cash of US$22.2m as well as receivables valued at US$303.1m due within 12 months. So its liabilities total US$1.20b more than the combination of its cash and short-term receivables.

Since publicly traded Advanced Drainage Systems shares are worth a total of US$8.61b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

We'd say that Advanced Drainage Systems's moderate net debt to EBITDA ratio ( being 1.9), indicates prudence when it comes to debt. And its commanding EBIT of 11.2 times its interest expense, implies the debt load is as light as a peacock feather. If Advanced Drainage Systems 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Advanced Drainage Systems 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Advanced Drainage Systems produced sturdy free cash flow equating to 78% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Advanced Drainage Systems's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its interest cover is also very heartening. Zooming out, Advanced Drainage Systems seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Advanced Drainage Systems you should know about.

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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