Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Aerometrex Limited (ASX:AMX) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Aerometrex

What Is Aerometrex's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Aerometrex had AU$2.02m of debt in June 2020, down from AU$11.6m, one year before. However, it does have AU$22.2m in cash offsetting this, leading to net cash of AU$20.2m.

How Strong Is Aerometrex's Balance Sheet?

The latest balance sheet data shows that Aerometrex had liabilities of AU$8.05m due within a year, and liabilities of AU$4.48m falling due after that. Offsetting this, it had AU$22.2m in cash and AU$3.08m in receivables that were due within 12 months. So it can boast AU$12.8m more liquid assets than total liabilities.

This surplus suggests that Aerometrex has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Aerometrex boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Aerometrex if management cannot prevent a repeat of the 75% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Aerometrex'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Aerometrex may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Aerometrex saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing up

While it is always sensible to investigate a company's debt, in this case Aerometrex has AU$20.2m in net cash and a decent-looking balance sheet. So while Aerometrex does not have a great balance sheet, it's certainly not too bad. 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, we've discovered 1 warning sign for Aerometrex 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.

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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