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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 ADX Energy Ltd (ASX:ADX) does have debt on its balance sheet. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is ADX Energy's Debt?
As you can see below, ADX Energy had AU$4.39m of debt at December 2021, down from AU$4.85m a year prior. However, its balance sheet shows it holds AU$5.94m in cash, so it actually has AU$1.55m net cash.
How Strong Is ADX Energy's Balance Sheet?
The latest balance sheet data shows that ADX Energy had liabilities of AU$8.54m due within a year, and liabilities of AU$15.9m falling due after that. On the other hand, it had cash of AU$5.94m and AU$2.56m worth of receivables due within a year. So its liabilities total AU$16.0m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of AU$24.4m, so it does suggest shareholders should keep an eye on ADX Energy's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, ADX Energy boasts net cash, so it's fair to say it does not have a heavy debt load! The balance sheet is clearly the area to focus on when you are analysing debt. But it is ADX Energy'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.
In the last year ADX Energy wasn't profitable at an EBIT level, but managed to grow its revenue by 41%, to AU$9.6m. With any luck the company will be able to grow its way to profitability.
So How Risky Is ADX Energy?
We have no doubt that loss making companies are, in general, riskier than profitable ones. And we do note that ADX Energy had an earnings before interest and tax (EBIT) loss, over the last year. And over the same period it saw negative free cash outflow of AU$3.1m and booked a AU$4.2m accounting loss. With only AU$1.55m on the balance sheet, it would appear that its going to need to raise capital again soon. ADX Energy's revenue growth shone bright over the last year, so it may well be in a position to turn a profit in due course. By investing before those profits, shareholders take on more risk in the hope of bigger rewards. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with ADX Energy (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.
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.
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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.