Algonquin Power & Utilities (TSE:AQN) Use Of Debt Could Be Considered Risky

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Algonquin Power & Utilities Corp. (TSE:AQN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Algonquin Power & Utilities

What Is Algonquin Power & Utilities's Debt?

As you can see below, at the end of March 2021, Algonquin Power & Utilities had US$6.44b of debt, up from US$4.33b a year ago. Click the image for more detail. On the flip side, it has US$142.5m in cash leading to net debt of about US$6.30b.

How Healthy Is Algonquin Power & Utilities' Balance Sheet?

According to the last reported balance sheet, Algonquin Power & Utilities had liabilities of US$1.40b due within 12 months, and liabilities of US$7.60b due beyond 12 months. On the other hand, it had cash of US$142.5m and US$366.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$8.50b.

This is a mountain of leverage relative to its market capitalization of US$9.51b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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 1.8 times and a disturbingly high net debt to EBITDA ratio of 9.6 hit our confidence in Algonquin Power & Utilities like a one-two punch to the gut. The debt burden here is substantial. More concerning, Algonquin Power & Utilities saw its EBIT drop by 6.8% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Algonquin Power & Utilities 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Algonquin Power & Utilities saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Algonquin Power & Utilities's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And even its level of total liabilities fails to inspire much confidence. We should also note that Integrated Utilities industry companies like Algonquin Power & Utilities commonly do use debt without problems. Overall, it seems to us that Algonquin Power & Utilities's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Be aware that Algonquin Power & Utilities is showing 5 warning signs in our investment analysis , and 1 of those can't be ignored...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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