Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Art's-Way Manufacturing Co., Inc. (NASDAQ:ARTW) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Art's-Way Manufacturing

What Is Art's-Way Manufacturing's Net Debt?

The chart below, which you can click on for greater detail, shows that Art's-Way Manufacturing had US$5.37m in debt in August 2019; about the same as the year before. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Art's-Way Manufacturing's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Art's-Way Manufacturing had liabilities of US$6.57m due within 12 months and liabilities of US$2.37m due beyond that. Offsetting these obligations, it had cash of US$5.0k as well as receivables valued at US$2.74m due within 12 months. So its liabilities total US$6.20m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of US$8.45m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Art's-Way Manufacturing 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.

Over 12 months, Art's-Way Manufacturing made a loss at the EBIT level, and saw its revenue drop to US$19m, which is a fall of 8.7%. That's not what we would hope to see.