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. As with many other companies Aveng Limited (JSE:AEG) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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 Aveng's Net Debt?
The image below, which you can click on for greater detail, shows that Aveng had debt of R828.0m at the end of June 2021, a reduction from R2.13b over a year. However, its balance sheet shows it holds R2.52b in cash, so it actually has R1.69b net cash.
How Healthy Is Aveng's Balance Sheet?
The latest balance sheet data shows that Aveng had liabilities of R7.56b due within a year, and liabilities of R1.44b falling due after that. On the other hand, it had cash of R2.52b and R3.70b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R2.78b.
This is a mountain of leverage relative to its market capitalization of R3.19b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Aveng also has more cash than debt, so we're pretty confident it can manage its debt safely.
Although Aveng made a loss at the EBIT level, last year, it was also good to see that it generated R261m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Aveng's earnings that will influence how the balance sheet holds up in the future. 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. While Aveng has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last year, Aveng actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Although Aveng's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of R1.69b. And it impressed us with free cash flow of R1.1b, being 419% of its EBIT. So we don't have any problem with Aveng's use of debt. 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. We've identified 3 warning signs with Aveng (at least 1 which is significant) , and understanding them should be part of your investment process.
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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