Here's Why ARC Resources (TSE:ARX) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, ARC Resources Ltd. (TSE:ARX) does carry debt. 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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for ARC Resources

What Is ARC Resources's Debt?

As you can see below, at the end of December 2021, ARC Resources had CA$1.71b of debt, up from CA$701.9m a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

A Look At ARC Resources' Liabilities

Zooming in on the latest balance sheet data, we can see that ARC Resources had liabilities of CA$1.51b due within 12 months and liabilities of CA$3.94b due beyond that. Offsetting these obligations, it had cash of CA$27.2m as well as receivables valued at CA$634.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$4.79b.

ARC Resources has a market capitalization of CA$11.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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

ARC Resources has net debt of just 0.84 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 9.1 times, which is more than adequate. Although ARC Resources made a loss at the EBIT level, last year, it was also good to see that it generated CA$1.1b in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if ARC Resources can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, ARC Resources generated free cash flow amounting to a very robust 84% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that ARC Resources's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its interest cover is also very heartening. Looking at all the aforementioned factors together, it strikes us that ARC Resources can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. To that end, you should learn about the 2 warning signs we've spotted with ARC Resources (including 1 which is significant) .

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. 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.