Is ADvTECH (JSE:ADH) Using Too Much Debt?

Warren Buffett famously said, '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. Importantly, ADvTECH Limited (JSE:ADH) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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, 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.

Check out our latest analysis for ADvTECH

What Is ADvTECH's Debt?

As you can see below, ADvTECH had R1.96b of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has R247.6m in cash leading to net debt of about R1.72b.

A Look At ADvTECH's Liabilities

According to the last reported balance sheet, ADvTECH had liabilities of R1.95b due within 12 months, and liabilities of R2.44b due beyond 12 months. Offsetting these obligations, it had cash of R247.6m as well as receivables valued at R506.2m due within 12 months. So it has liabilities totalling R3.64b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of R5.26b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

ADvTECH has net debt worth 1.6 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.8 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. ADvTECH grew its EBIT by 6.5% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since ADvTECH 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, ADvTECH created free cash flow amounting to 15% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Both ADvTECH's conversion of EBIT to free cash flow and its interest cover were discouraging. But its not so bad at growing its EBIT. Taking the abovementioned factors together we do think ADvTECH's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 2 warning signs for ADvTECH that you should be aware of before investing here.

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.

If you’re looking to trade ADvTECH, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

This article by Simply Wall St is general in nature. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.