Is ACS Actividades de Construcción y Servicios (BME:ACS) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 ACS, Actividades de Construcción y Servicios, S.A. (BME:ACS) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. 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.

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, ACS Actividades de Construcción y Servicios had €11.2b of debt at September 2021, down from €12.9b a year prior. However, it does have €6.21b in cash offsetting this, leading to net debt of about €5.02b.

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

The latest balance sheet data shows that ACS Actividades de Construcción y Servicios had liabilities of €21.7b due within a year, and liabilities of €11.0b falling due after that. Offsetting this, it had €6.21b in cash and €8.27b in receivables that were due within 12 months. So it has liabilities totalling €18.3b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the €6.64b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 26.4 hit our confidence in ACS Actividades de Construcción y Servicios like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, ACS Actividades de Construcción y Servicios's EBIT was down 79% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. 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'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. During the last three years, ACS Actividades de Construcción y Servicios generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

To be frank both ACS Actividades de Construcción y Servicios's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that ACS Actividades de Construcción y Servicios's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that ACS Actividades de Construcción y Servicios is showing 4 warning signs in our investment analysis , and 2 of those are significant...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.