Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. As with many other companies Atlas Engineered Products Ltd. (CVE:AEP) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

Check out our latest analysis for Atlas Engineered Products

The image below, which you can click on for greater detail, shows that at March 2022 Atlas Engineered Products had debt of CA$14.9m, up from CA$6.75m in one year. However, it does have CA$12.4m in cash offsetting this, leading to net debt of about CA$2.49m.

We can see from the most recent balance sheet that Atlas Engineered Products had liabilities of CA$10.8m falling due within a year, and liabilities of CA$16.5m due beyond that. Offsetting these obligations, it had cash of CA$12.4m as well as receivables valued at CA$6.79m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$8.19m.

While this might seem like a lot, it is not so bad since Atlas Engineered Products has a market capitalization of CA$31.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

Atlas Engineered Products has a low net debt to EBITDA ratio of only 0.19. And its EBIT easily covers its interest expense, being 29.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Atlas Engineered Products grew its EBIT by 518% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Atlas Engineered Products 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Atlas Engineered Products produced sturdy free cash flow equating to 73% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

The good news is that Atlas Engineered Products's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Considering this range of factors, it seems to us that Atlas Engineered Products is quite prudent with its debt, and the risks seem well managed. So we're not worried about the use of a little leverage on the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Atlas Engineered Products 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.

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.

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Atlas Engineered Products Ltd. designs, manufactures, and sells engineered roof trusses, floor trusses, wall panels, and windows in Canada.

Flawless balance sheet with outstanding track record.

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