Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Alliance Data Systems Corporation (NYSE:ADS) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Alliance Data Systems Carry?
The image below, which you can click on for greater detail, shows that Alliance Data Systems had debt of US$19.4b at the end of June 2020, a reduction from US$25.1b over a year. However, it does have US$4.96b in cash offsetting this, leading to net debt of about US$14.5b.
How Healthy Is Alliance Data Systems’s Balance Sheet?
According to the last reported balance sheet, Alliance Data Systems had liabilities of US$11.4b due within 12 months, and liabilities of US$10.3b due beyond 12 months. On the other hand, it had cash of US$4.96b and US$428.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$16.3b.
This deficit casts a shadow over the US$2.16b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Alliance Data Systems 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).
Alliance Data Systems has a rather high debt to EBITDA ratio of 17.5 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 6.5 times, suggesting it can responsibly service its obligations. Importantly, Alliance Data Systems’s EBIT fell a jaw-dropping 46% 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 Alliance Data Systems can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Alliance Data Systems actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
On the face of it, Alliance Data Systems’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 on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We’re quite clear that we consider Alliance Data Systems to be really rather risky, as a result of its balance sheet health. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We’ve spotted 6 warning signs for Alliance Data Systems you should be aware of, and 1 of them doesn’t sit too well with us.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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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