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.’ 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. We can see that Acciona, S.A. (BME:ANA) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Acciona’s Net Debt?
The image below, which you can click on for greater detail, shows that at June 2020 Acciona had debt of €6.53b, up from €6.22b in one year. However, because it has a cash reserve of €1.18b, its net debt is less, at about €5.35b.
A Look At Acciona’s Liabilities
The latest balance sheet data shows that Acciona had liabilities of €6.17b due within a year, and liabilities of €7.19b falling due after that. Offsetting this, it had €1.18b in cash and €2.35b in receivables that were due within 12 months. So its liabilities total €9.8b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the €5.40b 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. After all, Acciona would likely require a major re-capitalisation if it had to pay its creditors today.
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).
Weak interest cover of 1.7 times and a disturbingly high net debt to EBITDA ratio of 5.9 hit our confidence in Acciona like a one-two punch to the gut. The debt burden here is substantial. Worse, Acciona’s EBIT was down 31% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Acciona’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, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Acciona burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Acciona’s EBIT growth rate 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. And even its net debt to EBITDA fails to inspire much confidence. It’s also worth noting that Acciona is in the Electric Utilities industry, which is often considered to be quite defensive. Considering everything we’ve mentioned above, it’s fair to say that Acciona is carrying heavy debt load. If you play with fire you risk getting burnt, so we’d probably give this stock a wide berth. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we’ve spotted with Acciona (including 1 which is doesn’t sit too well with us) .
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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