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.' 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. We note that The a2 Milk Company Limited (NZSE:ATM) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is a2 Milk's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2022 a2 Milk had NZ$107.0m of debt, an increase on none, over one year. But on the other hand it also has NZ$887.3m in cash, leading to a NZ$780.3m net cash position.
A Look At a2 Milk's Liabilities
According to the last reported balance sheet, a2 Milk had liabilities of NZ$440.2m due within 12 months, and liabilities of NZ$81.7m due beyond 12 months. Offsetting these obligations, it had cash of NZ$887.3m as well as receivables valued at NZ$89.4m due within 12 months. So it can boast NZ$454.8m more liquid assets than total liabilities.
This short term liquidity is a sign that a2 Milk could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that a2 Milk has more cash than debt is arguably a good indication that it can manage its debt safely.
On top of that, a2 Milk grew its EBIT by 40% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine a2 Milk's ability to maintain a healthy balance sheet going forward. 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. While a2 Milk 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. During the last three years, a2 Milk generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
While we empathize with investors who find debt concerning, you should keep in mind that a2 Milk has net cash of NZ$780.3m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of NZ$199m, being 82% of its EBIT. So is a2 Milk's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for a2 Milk that you should be aware of before investing here.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
Join A Paid User Research Session
You’ll receive a US$30 Amazon Gift card for 1 hour of your time while helping us build better investing tools for the individual investors like yourself. Sign up here