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.' 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 Aena S.M.E., S.A. (BME:AENA) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Aena S.M.E Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Aena S.M.E had €8.53b of debt, an increase on €7.07b, over one year. However, it also had €1.73b in cash, and so its net debt is €6.80b.
How Strong Is Aena S.M.E's Balance Sheet?
We can see from the most recent balance sheet that Aena S.M.E had liabilities of €2.26b falling due within a year, and liabilities of €7.58b due beyond that. On the other hand, it had cash of €1.73b and €662.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €7.44b.
While this might seem like a lot, it is not so bad since Aena S.M.E has a huge market capitalization of €21.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
Aena S.M.E has a rather high debt to EBITDA ratio of 5.6 which suggests a meaningful debt load. However, its interest coverage of 3.5 is reasonably strong, which is a good sign. Worse, Aena S.M.E's EBIT was down 78% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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 Aena S.M.E'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. Over the most recent three years, Aena S.M.E recorded free cash flow worth 62% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While Aena S.M.E's net debt to EBITDA makes us cautious about it, its track record of (not) growing its EBIT is no better. At least its conversion of EBIT to free cash flow gives us reason to be optimistic. It's also worth noting that Aena S.M.E is in the Infrastructure industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Aena S.M.E's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with Aena S.M.E (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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This article by Simply Wall St is general in nature. 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.
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