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.' 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 can see that Atlas Arteria Limited (ASX:ALX) does use debt in its business. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Atlas Arteria's Debt?
You can click the graphic below for the historical numbers, but it shows that Atlas Arteria had AU$1.54b of debt in December 2020, down from AU$2.19b, one year before. However, it does have AU$260.3m in cash offsetting this, leading to net debt of about AU$1.28b.
How Strong Is Atlas Arteria's Balance Sheet?
We can see from the most recent balance sheet that Atlas Arteria had liabilities of AU$72.0m falling due within a year, and liabilities of AU$1.56b due beyond that. On the other hand, it had cash of AU$260.3m and AU$5.68m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$1.37b.
This deficit isn't so bad because Atlas Arteria is worth AU$5.90b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Atlas Arteria's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
In the last year Atlas Arteria had a loss before interest and tax, and actually shrunk its revenue by 39%, to AU$107m. That makes us nervous, to say the least.
Not only did Atlas Arteria's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost AU$29m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. We would feel better if it turned its trailing twelve month loss of AU$16m into a profit. So we do think this stock is quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Atlas Arteria 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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