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 note that Afrimat Limited (JSE:AFT) does have debt on its balance sheet. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
View our latest analysis for Afrimat
How Much Debt Does Afrimat Carry?
You can click the graphic below for the historical numbers, but it shows that Afrimat had R207.2m of debt in August 2020, down from R293.6m, one year before. However, it does have R374.4m in cash offsetting this, leading to net cash of R167.2m.
How Strong Is Afrimat's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Afrimat had liabilities of R658.4m due within 12 months and liabilities of R495.7m due beyond that. Offsetting this, it had R374.4m in cash and R531.2m in receivables that were due within 12 months. So it has liabilities totalling R248.4m more than its cash and near-term receivables, combined.
Since publicly traded Afrimat shares are worth a total of R5.91b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Afrimat boasts net cash, so it's fair to say it does not have a heavy debt load!
The good news is that Afrimat has increased its EBIT by 7.0% over twelve months, which should ease any concerns about debt repayment. 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 Afrimat 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. While Afrimat 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 most recent three years, Afrimat recorded free cash flow worth 76% 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.
Summing up
We could understand if investors are concerned about Afrimat's liabilities, but we can be reassured by the fact it has has net cash of R167.2m. The cherry on top was that in converted 76% of that EBIT to free cash flow, bringing in R441m. So we don't think Afrimat's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Afrimat .
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. 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.
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About JSE:AFT
Afrimat
Operates as a mining and materials company primarily in the southern African region.
High growth potential and good value.
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