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. Importantly, ARC Document Solutions, Inc. (NYSE:ARC) does carry debt. 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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is ARC Document Solutions’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 ARC Document Solutions had debt of US$64.6m, up from US$132 in one year. However, it also had US$20.8m in cash, and so its net debt is US$43.8m.
How Healthy Is ARC Document Solutions’s Balance Sheet?
The latest balance sheet data shows that ARC Document Solutions had liabilities of US$88.9m due within a year, and liabilities of US$125.9m falling due after that. On the other hand, it had cash of US$20.8m and US$57.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$136.3m.
The deficiency here weighs heavily on the US$63.8m 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, ARC Document Solutions would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Looking at its net debt to EBITDA of 0.94 and interest cover of 2.8 times, it seems to us that ARC Document Solutions is probably using debt in a pretty reasonable way. So we’d recommend keeping a close eye on the impact financing costs are having on the business. Sadly, ARC Document Solutions’s EBIT actually dropped 9.4% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since ARC Document Solutions 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, ARC Document Solutions actually produced more free cash flow than EBIT over the last three years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
We’d go so far as to say ARC Document Solutions’s level of total liabilities was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, we think it’s fair to say that ARC Document Solutions has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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