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 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. We note that Aroundtown SA (ETR:AT1) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Aroundtown's Debt?
The image below, which you can click on for greater detail, shows that Aroundtown had debt of €11.4b at the end of March 2021, a reduction from €12.6b over a year. However, because it has a cash reserve of €2.88b, its net debt is less, at about €8.49b.
A Look At Aroundtown's Liabilities
We can see from the most recent balance sheet that Aroundtown had liabilities of €827.2m falling due within a year, and liabilities of €14.1b due beyond that. On the other hand, it had cash of €2.88b and €595.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €11.4b.
Given this deficit is actually higher than the company's market capitalization of €7.81b, we think shareholders really should watch Aroundtown's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Aroundtown has a rather high debt to EBITDA ratio of 8.4 which suggests a meaningful debt load. However, its interest coverage of 5.1 is reasonably strong, which is a good sign. Aroundtown grew its EBIT by 9.9% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 Aroundtown'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Aroundtown produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
On the face of it, Aroundtown's level of total liabilities left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Aroundtown's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. To that end, you should learn about the 4 warning signs we've spotted with Aroundtown (including 1 which doesn't sit too well with us) .
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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