Here's Why ACS Actividades de Construcción y Servicios (BME:ACS) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, ACS, Actividades de Construcción y Servicios, S.A. (BME:ACS) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for ACS Actividades de Construcción y Servicios

What Is ACS Actividades de Construcción y Servicios's Debt?

The image below, which you can click on for greater detail, shows that at June 2024 ACS Actividades de Construcción y Servicios had debt of €12.6b, up from €10.3b in one year. However, because it has a cash reserve of €10.8b, its net debt is less, at about €1.79b.

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

We can see from the most recent balance sheet that ACS Actividades de Construcción y Servicios had liabilities of €21.6b falling due within a year, and liabilities of €14.3b due beyond that. Offsetting this, it had €10.8b in cash and €11.0b in receivables that were due within 12 months. So its liabilities total €14.2b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's huge €11.2b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).

While ACS Actividades de Construcción y Servicios has a quite reasonable net debt to EBITDA multiple of 2.2, its interest cover seems weak, at 1.5. The main reason for this is that it has such high depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Importantly, ACS Actividades de Construcción y Servicios's EBIT fell a jaw-dropping 33% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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. Happily for any shareholders, ACS Actividades de Construcción y Servicios actually produced more free cash flow than EBIT over the last two years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both ACS Actividades de Construcción y Servicios's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. 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. 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. Be aware that ACS Actividades de Construcción y Servicios is showing 2 warning signs in our investment analysis , 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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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.