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 can see that Allied Machinery Co., Ltd. (SHSE:605060) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Allied Machinery Carry?
You can click the graphic below for the historical numbers, but it shows that Allied Machinery had CN¥90.0m of debt in December 2023, down from CN¥251.7m, one year before. But on the other hand it also has CN¥689.4m in cash, leading to a CN¥599.4m net cash position.
How Strong Is Allied Machinery's Balance Sheet?
We can see from the most recent balance sheet that Allied Machinery had liabilities of CN¥369.2m falling due within a year, and liabilities of CN¥56.1m due beyond that. Offsetting this, it had CN¥689.4m in cash and CN¥389.9m in receivables that were due within 12 months. So it can boast CN¥654.0m more liquid assets than total liabilities.
This excess liquidity suggests that Allied Machinery is taking a careful approach to debt. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, Allied Machinery boasts net cash, so it's fair to say it does not have a heavy debt load!
Also good is that Allied Machinery grew its EBIT at 15% over the last year, further increasing its ability to manage debt. 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 Allied Machinery 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 Allied Machinery 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. Considering the last three years, Allied Machinery actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Allied Machinery has net cash of CN¥599.4m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 15% over the last year. So we don't have any problem with Allied Machinery's use of debt. 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. Case in point: We've spotted 1 warning sign for Allied Machinery you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.