Is Air Canada (TSE:AC) 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.' 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 note that Air Canada (TSE:AC) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Air Canada

What Is Air Canada's Net Debt?

The image below, which you can click on for greater detail, shows that Air Canada had debt of CA$11.7b at the end of September 2023, a reduction from CA$13.9b over a year. However, it does have CA$8.29b in cash offsetting this, leading to net debt of about CA$3.41b.

How Strong Is Air Canada's Balance Sheet?

The latest balance sheet data shows that Air Canada had liabilities of CA$9.33b due within a year, and liabilities of CA$19.8b falling due after that. Offsetting this, it had CA$8.29b in cash and CA$1.20b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$19.7b.

This deficit casts a shadow over the CA$6.55b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Air Canada would likely require a major re-capitalisation if it had to pay its creditors today.

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.

While Air Canada's low debt to EBITDA ratio of 1.1 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.8 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We also note that Air Canada improved its EBIT from a last year's loss to a positive CA$2.2b. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Air Canada's ability to maintain a healthy balance sheet going forward. 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Air Canada actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Neither Air Canada's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Air Canada'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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Air Canada is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

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.

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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.