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.’ 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 note that Acerinox, S.A. (BME:ACX) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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.
What Is Acerinox’s Debt?
The image below, which you can click on for greater detail, shows that at June 2020 Acerinox had debt of €1.97b, up from €1.48b in one year. However, it does have €1.12b in cash offsetting this, leading to net debt of about €856.8m.
How Strong Is Acerinox’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Acerinox had liabilities of €1.49b due within 12 months and liabilities of €1.86b due beyond that. Offsetting these obligations, it had cash of €1.12b as well as receivables valued at €592.5m due within 12 months. So it has liabilities totalling €1.6b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of €1.99b, so it does suggest shareholders should keep an eye on Acerinox’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Acerinox’s net debt of 2.5 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.5 times interest expense) certainly does not do anything to dispel this impression. Importantly, Acerinox’s EBIT fell a jaw-dropping 23% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Acerinox can strengthen its balance sheet over time. 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Acerinox recorded free cash flow worth a fulsome 91% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
Neither Acerinox’s ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Acerinox is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. Be aware that Acerinox is showing 2 warning signs in our investment analysis , and 1 of those is significant…
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.
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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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