Is Arcos Dorados Holdings (NYSE:ARCO) A Risky Investment?

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. 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 Arcos Dorados Holdings Inc. (NYSE:ARCO) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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.

View our latest analysis for Arcos Dorados Holdings

What Is Arcos Dorados Holdings’s Net Debt?

The chart below, which you can click on for greater detail, shows that Arcos Dorados Holdings had US$637.9m in debt in September 2019; about the same as the year before. However, because it has a cash reserve of US$126.7m, its net debt is less, at about US$511.2m.

NYSE:ARCO Historical Debt, February 20th 2020
NYSE:ARCO Historical Debt, February 20th 2020

How Healthy Is Arcos Dorados Holdings’s Balance Sheet?

According to the last reported balance sheet, Arcos Dorados Holdings had liabilities of US$495.2m due within 12 months, and liabilities of US$1.44b due beyond 12 months. Offsetting this, it had US$126.7m in cash and US$86.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.73b.

Given this deficit is actually higher than the company’s market capitalization of US$1.49b, we think shareholders really should watch Arcos Dorados Holdings’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Arcos Dorados Holdings has net debt worth 1.9 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 2.9 times the interest expense. While that doesn’t worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, Arcos Dorados Holdings grew its EBIT by 57% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Arcos Dorados Holdings 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Arcos Dorados Holdings recorded free cash flow of 24% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.

Our View

Arcos Dorados Holdings’s level of total liabilities and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Arcos Dorados Holdings’s debt poses some risks to the business. 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. For example, we’ve discovered 3 warning signs for Arcos Dorados Holdings (1 can’t be ignored!) that you should be aware of before investing here.

At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

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