David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Avance Gas Holding Ltd (OB:AVANCE) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Avance Gas Holding

What Is Avance Gas Holding's Net Debt?

The chart below, which you can click on for greater detail, shows that Avance Gas Holding had US$521.1m in debt in June 2019; about the same as the year before. However, it also had US$67.0m in cash, and so its net debt is US$454.1m.

A Look At Avance Gas Holding's Liabilities

The latest balance sheet data shows that Avance Gas Holding had liabilities of US$52.6m due within a year, and liabilities of US$476.2m falling due after that. Offsetting these obligations, it had cash of US$67.0m as well as receivables valued at US$27.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$434.1m.

The deficiency here weighs heavily on the US$231.2m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we'd watch its balance sheet closely, without a doubt At the end of the day, Avance Gas Holding would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Weak interest cover of 0.43 times and a disturbingly high net debt to EBITDA ratio of 8.7 hit our confidence in Avance Gas Holding like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for Avance Gas Holding is that it turned last year's EBIT loss into a gain of US$13m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Avance Gas Holding can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Avance Gas Holding reported free cash flow worth 7.6% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Avance Gas Holding's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. After considering the datapoints discussed, we think Avance Gas Holding has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given our concerns about Avance Gas Holding's debt levels, it seems only prudent to check if insiders have been ditching the stock.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.