Is Algonquin Power & Utilities (TSE:AQN) A Risky Investment?

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.' 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. Importantly, Algonquin Power & Utilities Corp. (TSE:AQN) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

View our latest analysis for Algonquin Power & Utilities

What Is Algonquin Power & Utilities's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Algonquin Power & Utilities had US$9.14b of debt, an increase on US$7.90b, over one year. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Algonquin Power & Utilities' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Algonquin Power & Utilities had liabilities of US$1.20b due within 12 months and liabilities of US$10.7b due beyond that. On the other hand, it had cash of US$86.3m and US$534.1m worth of receivables due within a year. So it has liabilities totalling US$11.2b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$4.59b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Algonquin Power & Utilities 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Algonquin Power & Utilities shareholders face the double whammy of a high net debt to EBITDA ratio (9.5), and fairly weak interest coverage, since EBIT is just 1.3 times the interest expense. This means we'd consider it to have a heavy debt load. Even more troubling is the fact that Algonquin Power & Utilities actually let its EBIT decrease by 5.3% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. 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 investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Algonquin Power & Utilities's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. We should also note that Integrated Utilities industry companies like Algonquin Power & Utilities commonly do use debt without problems. Considering all the factors previously mentioned, we think that Algonquin Power & Utilities really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Algonquin Power & Utilities is showing 3 warning signs in our investment analysis , and 2 of those are significant...

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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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.

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