The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies AdAlta Limited (ASX:1AD) makes use of debt. But the real question is whether this debt is making the company risky.
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 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does AdAlta Carry?
As you can see below, at the end of June 2022, AdAlta had AU$4.00m of debt, up from AU$1.69m a year ago. Click the image for more detail. However, it does have AU$8.66m in cash offsetting this, leading to net cash of AU$4.66m.
How Healthy Is AdAlta's Balance Sheet?
According to the last reported balance sheet, AdAlta had liabilities of AU$3.63m due within 12 months, and liabilities of AU$1.64m due beyond 12 months. On the other hand, it had cash of AU$8.66m and AU$1.67m worth of receivables due within a year. So it actually has AU$5.06m more liquid assets than total liabilities.
This surplus liquidity suggests that AdAlta's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that AdAlta has more cash than debt is arguably a good indication that it can manage its debt safely. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since AdAlta 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.
In the last year AdAlta had a loss before interest and tax, and actually shrunk its revenue by 31%, to AU$2.8m. That makes us nervous, to say the least.
So How Risky Is AdAlta?
By their very nature companies that are losing money are more risky than those with a long history of profitability. And in the last year AdAlta had an earnings before interest and tax (EBIT) loss, truth be told. Indeed, in that time it burnt through AU$4.1m of cash and made a loss of AU$6.1m. Given it only has net cash of AU$4.66m, the company may need to raise more capital if it doesn't reach break-even soon. Even though its balance sheet seems sufficiently liquid, debt always makes us a little nervous if a company doesn't produce free cash flow regularly. 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 AdAlta has 4 warning signs (and 1 which is significant) we think you should know about.
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.
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