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. We can see that APA Group (ASX:APA) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for APA Group
What Is APA Group's Net Debt?
As you can see below, at the end of December 2022, APA Group had AU$11.1b of debt, up from AU$10.0b a year ago. Click the image for more detail. However, it also had AU$674.8m in cash, and so its net debt is AU$10.4b.
How Strong Is APA Group's Balance Sheet?
According to the last reported balance sheet, APA Group had liabilities of AU$1.05b due within 12 months, and liabilities of AU$12.4b due beyond 12 months. Offsetting these obligations, it had cash of AU$674.8m as well as receivables valued at AU$436.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$12.4b.
When you consider that this deficiency exceeds the company's AU$12.3b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 6.2 hit our confidence in APA Group like a one-two punch to the gut. The debt burden here is substantial. Fortunately, APA Group grew its EBIT by 5.5% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if APA Group 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, APA Group produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
On the face of it, APA Group's interest cover left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. It's also worth noting that APA Group is in the Gas Utilities industry, which is often considered to be quite defensive. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making APA Group stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 2 warning signs for APA Group that you should be aware of before investing here.
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.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.
About ASX:APA
Undervalued with solid track record and pays a dividend.
