Is Algonquin Power & Utilities (TSE:AQN) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We can see that Algonquin Power & Utilities Corp. (TSE:AQN) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Algonquin Power & Utilities

What Is Algonquin Power & Utilities's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Algonquin Power & Utilities had debt of US$8.41b, up from US$7.77b in one year. Net debt is about the same, since the it doesn't have much cash.

A Look At Algonquin Power & Utilities' Liabilities

We can see from the most recent balance sheet that Algonquin Power & Utilities had liabilities of US$1.51b falling due within a year, and liabilities of US$9.62b due beyond that. On the other hand, it had cash of US$94.8m and US$424.0m worth of receivables due within a year. So its liabilities total US$10.6b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$4.46b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Algonquin Power & Utilities would likely require a major re-capitalisation if it had to pay its creditors today.

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 (8.9), and fairly weak interest coverage, since EBIT is just 1.4 times the interest expense. The debt burden here is substantial. The good news is that Algonquin Power & Utilities improved its EBIT by 6.1% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. 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 Algonquin Power & Utilities's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Algonquin Power & Utilities burned a lot of cash. 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. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Integrated Utilities industry companies like Algonquin Power & Utilities commonly do use debt without problems. After considering the datapoints discussed, we think Algonquin Power & Utilities has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Algonquin Power & Utilities (of which 2 are concerning!) you should know about.

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.