Here's Why Aguas Andinas (SNSE:AGUAS-A) Has A Meaningful Debt Burden

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Aguas Andinas S.A. (SNSE:AGUAS-A) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Aguas Andinas

What Is Aguas Andinas's Debt?

As you can see below, at the end of September 2022, Aguas Andinas had CL$1.24t of debt, up from CL$1.12t a year ago. Click the image for more detail. However, because it has a cash reserve of CL$163.3b, its net debt is less, at about CL$1.08t.

How Strong Is Aguas Andinas' Balance Sheet?

According to the last reported balance sheet, Aguas Andinas had liabilities of CL$252.6b due within 12 months, and liabilities of CL$1.21t due beyond 12 months. Offsetting these obligations, it had cash of CL$163.3b as well as receivables valued at CL$105.2b due within 12 months. So its liabilities total CL$1.19t more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of CL$1.42t, so it does suggest shareholders should keep an eye on Aguas Andinas' use of debt. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Aguas Andinas has a debt to EBITDA ratio of 4.0, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 10.6 is very high, suggesting that the interest expense on the debt is currently quite low. We saw Aguas Andinas grow its EBIT by 8.1% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Aguas Andinas recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Aguas Andinas's ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. 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. Looking at all the angles mentioned above, it does seem to us that Aguas Andinas is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For instance, we've identified 2 warning signs for Aguas Andinas (1 makes us a bit uncomfortable) you should be aware of.

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.