Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 note that Aristocrat Leisure Limited (ASX:ALL) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.
What Is Aristocrat Leisure’s Debt?
The image below, which you can click on for greater detail, shows that at March 2020 Aristocrat Leisure had debt of AU$3.21b, up from AU$2.95b in one year. On the flip side, it has AU$878.4m in cash leading to net debt of about AU$2.33b.
How Healthy Is Aristocrat Leisure’s Balance Sheet?
We can see from the most recent balance sheet that Aristocrat Leisure had liabilities of AU$1.08b falling due within a year, and liabilities of AU$3.62b due beyond that. Offsetting this, it had AU$878.4m in cash and AU$932.2m in receivables that were due within 12 months. So its liabilities total AU$2.9b more than the combination of its cash and short-term receivables.
Of course, Aristocrat Leisure has a titanic market capitalization of AU$18.7b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a debt to EBITDA ratio of 1.7, Aristocrat Leisure uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.2 times its interest expenses harmonizes with that theme. Importantly Aristocrat Leisure’s EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Aristocrat Leisure 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Aristocrat Leisure produced sturdy free cash flow equating to 75% 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.
Happily, Aristocrat Leisure’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And we also thought its interest cover was a positive. When we consider the range of factors above, it looks like Aristocrat Leisure is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. For instance, we’ve identified 2 warning signs for Aristocrat Leisure (1 shouldn’t be ignored) you should be aware of.
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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