ALS (ASX:ALQ) Seems To Use Debt Quite Sensibly

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.' 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 ALS Limited (ASX:ALQ) does use debt in its business. But is this debt a concern to shareholders?

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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for ALS

What Is ALS's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2020 ALS had AU$1.23b of debt, an increase on AU$779.9m, over one year. However, it also had AU$424.4m in cash, and so its net debt is AU$803.1m.

How Healthy Is ALS's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that ALS had liabilities of AU$587.1m due within 12 months and liabilities of AU$1.23b due beyond that. Offsetting this, it had AU$424.4m in cash and AU$365.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$1.0b.

This deficit isn't so bad because ALS is worth AU$4.22b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

With a debt to EBITDA ratio of 2.1, ALS uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 7.1 times its interest expenses harmonizes with that theme. We saw ALS grow its EBIT by 6.7% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine ALS'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, ALS recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

ALS's interest cover was a real positive on this analysis, as was its EBIT growth rate. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that ALS is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Consider risks, for instance. Every company has them, and we've spotted 4 warning signs for ALS you should know about.

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. 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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