These 4 Measures Indicate That Algonquin Power & Utilities (TSE:AQN) Is Using Debt In A Risky Way

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.' 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 note that Algonquin Power & Utilities Corp. (TSE:AQN) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Algonquin Power & Utilities

How Much Debt Does Algonquin Power & Utilities Carry?

As you can see below, Algonquin Power & Utilities had US$8.33b of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn't have much cash.

A Look At Algonquin Power & Utilities' Liabilities

Zooming in on the latest balance sheet data, we can see that Algonquin Power & Utilities had liabilities of US$1.24b due within 12 months and liabilities of US$9.93b due beyond that. Offsetting these obligations, it had cash of US$131.6m as well as receivables valued at US$426.9m due within 12 months. So it has liabilities totalling US$10.6b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$4.23b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Algonquin Power & Utilities would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 8.5 hit our confidence in Algonquin Power & Utilities like a one-two punch to the gut. The debt burden here is substantial. Even more troubling is the fact that Algonquin Power & Utilities actually let its EBIT decrease by 4.9% over the last year. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Algonquin Power & Utilities burned a lot of cash. 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 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. Taking into account all the aforementioned factors, it looks like Algonquin Power & Utilities has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 4 warning signs for Algonquin Power & Utilities (2 are significant) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.