Is Advanced Drainage Systems (NYSE:WMS) 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 can see that Advanced Drainage Systems, Inc. (NYSE:WMS) does use debt in its business. But is this debt a concern to shareholders?

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What Risk Does Debt Bring?

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 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.

How Much Debt Does Advanced Drainage Systems Carry?

The chart below, which you can click on for greater detail, shows that Advanced Drainage Systems had US$1.26b in debt in December 2024; about the same as the year before. On the flip side, it has US$488.9m in cash leading to net debt of about US$767.9m.

How Healthy Is Advanced Drainage Systems' Balance Sheet?

The latest balance sheet data shows that Advanced Drainage Systems had liabilities of US$388.1m due within a year, and liabilities of US$1.75b falling due after that. Offsetting these obligations, it had cash of US$488.9m as well as receivables valued at US$247.9m due within 12 months. So its liabilities total US$1.40b more than the combination of its cash and short-term receivables.

Of course, Advanced Drainage Systems has a market capitalization of US$8.20b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

See our latest analysis for Advanced Drainage Systems

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).

Advanced Drainage Systems's net debt is only 0.91 times its EBITDA. And its EBIT easily covers its interest expense, being 10.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Advanced Drainage Systems saw its EBIT drop by 4.1% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Advanced Drainage Systems 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Advanced Drainage Systems recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Advanced Drainage Systems's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that Advanced Drainage Systems can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. For example, we've discovered 1 warning sign for Advanced Drainage Systems that you should be aware of before investing here.

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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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.