The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. As with many other companies ACS, Actividades de Construcción y Servicios, S.A. (BME:ACS) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
What Is ACS Actividades de Construcción y Servicios’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 ACS Actividades de Construcción y Servicios had €12.9b of debt, an increase on €8.29b, over one year. However, because it has a cash reserve of €10.0b, its net debt is less, at about €2.88b.
How Healthy Is ACS Actividades de Construcción y Servicios’s Balance Sheet?
According to the last reported balance sheet, ACS Actividades de Construcción y Servicios had liabilities of €22.6b due within 12 months, and liabilities of €12.3b due beyond 12 months. Offsetting this, it had €10.0b in cash and €12.0b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €12.9b.
The deficiency here weighs heavily on the €5.94b 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 definitely think shareholders need to watch this one closely. After all, ACS Actividades de Construcción y Servicios 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
ACS Actividades de Construcción y Servicios’s net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its strong interest cover of 11.3 times, makes us even more comfortable. Importantly, ACS Actividades de Construcción y Servicios’s EBIT fell a jaw-dropping 56% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if ACS Actividades de Construcción y Servicios 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, ACS Actividades de Construcción y Servicios produced sturdy free cash flow equating to 66% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On the face of it, ACS Actividades de Construcción y Servicios’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. But at least it’s pretty decent at covering its interest expense with its EBIT; that’s encouraging. Overall, we think it’s fair to say that ACS Actividades de Construcción y Servicios has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Case in point: We’ve spotted 4 warning signs for ACS Actividades de Construcción y Servicios you should be aware of, and 1 of them can’t be ignored.
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.
If you decide to trade ACS Actividades de Construcción y Servicios, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account.
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email firstname.lastname@example.org.