We Think Aguas Andinas (SNSE:AGUAS-A) Is Taking Some Risk With Its Debt

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Aguas Andinas S.A. (SNSE:AGUAS-A) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Aguas Andinas

What Is Aguas Andinas's Debt?

As you can see below, Aguas Andinas had CL$1.08t of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of CL$174.9b, its net debt is less, at about CL$900.1b.

How Strong Is Aguas Andinas' Balance Sheet?

The latest balance sheet data shows that Aguas Andinas had liabilities of CL$244.0b due within a year, and liabilities of CL$1.06t falling due after that. Offsetting these obligations, it had cash of CL$174.9b as well as receivables valued at CL$115.7b due within 12 months. So it has liabilities totalling CL$1.01t more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CL$1.24t. 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 3.9 and its EBIT covered its interest expense 6.8 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Shareholders should be aware that Aguas Andinas's EBIT was down 24% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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 38% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over Aguas Andinas's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. It's also worth noting that Aguas Andinas is in the Water Utilities industry, which is often considered to be quite defensive. Overall, we think it's fair to say that Aguas Andinas has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. We've identified 3 warning signs with Aguas Andinas (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

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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