The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Ashtead Group plc (LON:AHT) does use debt in its business. 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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Ashtead Group Carry?
You can click the graphic below for the historical numbers, but it shows that as of April 2020 Ashtead Group had UK£4.49b of debt, an increase on UK£3.75b, over one year. On the flip side, it has UK£241.4m in cash leading to net debt of about UK£4.25b.
A Look At Ashtead Group's Liabilities
We can see from the most recent balance sheet that Ashtead Group had liabilities of UK£736.7m falling due within a year, and liabilities of UK£6.82b due beyond that. Offsetting these obligations, it had cash of UK£241.4m as well as receivables valued at UK£854.4m due within 12 months. So it has liabilities totalling UK£6.5b more than its cash and near-term receivables, combined.
Ashtead Group has a very large market capitalization of UK£11.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Ashtead Group has net debt worth 1.9 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.1 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Notably Ashtead Group's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Ashtead Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Ashtead Group's free cash flow amounted to 44% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Both Ashtead Group's level of total liabilities and its conversion of EBIT to free cash flow were discouraging. At least its net debt to EBITDA gives us reason to be optimistic. We think that Ashtead Group's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we've spotted 2 warning signs for Ashtead Group you should know about.
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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Ashtead Group plc, together with its subsidiaries, engages in the construction, industrial, and general equipment rental business in the United States, the United Kingdom, and Canada.
Solid track record with adequate balance sheet and pays a dividend.