ACS Actividades de Construcción y Servicios (BME:ACS) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that ACS, Actividades de Construcción y Servicios, S.A. (BME:ACS) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for ACS Actividades de Construcción y Servicios

How Much Debt Does ACS Actividades de Construcción y Servicios Carry?

As you can see below, at the end of December 2020, ACS Actividades de Construcción y Servicios had €11.2b of debt, up from €9.46b a year ago. Click the image for more detail. On the flip side, it has €9.44b in cash leading to net debt of about €1.80b.

How Healthy Is ACS Actividades de Construcción y Servicios' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that ACS Actividades de Construcción y Servicios had liabilities of €21.6b due within 12 months and liabilities of €10.6b due beyond that. On the other hand, it had cash of €9.44b and €10.5b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €12.3b.

The deficiency here weighs heavily on the €7.72b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, ACS Actividades de Construcción y Servicios would probably need a major re-capitalization if its creditors were to demand repayment.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Looking at its net debt to EBITDA of 0.82 and interest cover of 4.5 times, it seems to us that ACS Actividades de Construcción y Servicios is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Shareholders should be aware that ACS Actividades de Construcción y Servicios's EBIT was down 22% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine ACS Actividades de Construcción y Servicios'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, ACS Actividades de Construcción y Servicios produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, ACS Actividades de Construcción y Servicios's level of total liabilities left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, we think it's fair to say that ACS Actividades de Construcción y Servicios has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For example ACS Actividades de Construcción y Servicios has 3 warning signs (and 1 which can't be ignored) we think you should know about.

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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