Here's Why ATCO (TSE:ACO.X) Is Weighed Down By Its Debt Load

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 note that ATCO Ltd. (TSE:ACO.X) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for ATCO

What Is ATCO's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 ATCO had CA$10.1b of debt, an increase on CA$9.65b, over one year. However, because it has a cash reserve of CA$1.09b, its net debt is less, at about CA$8.98b.

How Healthy Is ATCO's Balance Sheet?

We can see from the most recent balance sheet that ATCO had liabilities of CA$1.59b falling due within a year, and liabilities of CA$13.5b due beyond that. Offsetting this, it had CA$1.09b in cash and CA$898.0m in receivables that were due within 12 months. So it has liabilities totalling CA$13.1b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CA$5.21b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, ATCO would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 2.3 times and a disturbingly high net debt to EBITDA ratio of 5.5 hit our confidence in ATCO like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. More concerning, ATCO saw its EBIT drop by 5.4% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its 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 ATCO'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, ATCO produced sturdy free cash flow equating to 50% 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, ATCO's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. We should also note that Integrated Utilities industry companies like ATCO commonly do use debt without problems. We're quite clear that we consider ATCO to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for ATCO 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. 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.