Aguas Andinas (SNSE:AGUAS-A) Takes On Some Risk With Its Use Of 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.' 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. As with many other companies Aguas Andinas S.A. (SNSE:AGUAS-A) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Aguas Andinas

What Is Aguas Andinas's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2023 Aguas Andinas had debt of CL$1.30t, up from CL$1.20t in one year. However, it also had CL$165.2b in cash, and so its net debt is CL$1.14t.

How Healthy Is Aguas Andinas' Balance Sheet?

We can see from the most recent balance sheet that Aguas Andinas had liabilities of CL$290.7b falling due within a year, and liabilities of CL$1.22t due beyond that. Offsetting this, it had CL$165.2b in cash and CL$113.9b in receivables that were due within 12 months. So it has liabilities totalling CL$1.24t more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CL$1.60t. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Aguas Andinas has a debt to EBITDA ratio of 3.6, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 13.7 is very high, suggesting that the interest expense on the debt is currently quite low. We saw Aguas Andinas grow its EBIT by 9.0% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off 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 Aguas Andinas 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Aguas Andinas recorded free cash flow of 29% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Aguas Andinas's net debt to EBITDA and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. It's also worth noting that Aguas Andinas is in the Water Utilities industry, which is often considered to be quite defensive. We think that Aguas Andinas's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Aguas Andinas is showing 2 warning signs in our investment analysis , and 1 of those is significant...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.