Stock Analysis

These 4 Measures Indicate That Ashtead Group (LON:AHT) Is Using Debt Extensively

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LSE:AHT
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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 Ashtead Group plc (LON:AHT) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

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What Is Ashtead Group's Net Debt?

The image below, which you can click on for greater detail, shows that Ashtead Group had debt of UK£3.58b at the end of October 2020, a reduction from UK£4.26b over a year. Net debt is about the same, since the it doesn't have much cash.

debt-equity-history-analysis
LSE:AHT Debt to Equity History February 22nd 2021

How Healthy Is Ashtead Group's Balance Sheet?

The latest balance sheet data shows that Ashtead Group had liabilities of UK£898.4m due within a year, and liabilities of UK£5.84b falling due after that. Offsetting these obligations, it had cash of UK£14.1m as well as receivables valued at UK£908.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£5.81b.

Ashtead Group has a very large market capitalization of UK£17.8b, 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Ashtead Group has net debt worth 1.6 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.6 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. The bad news is that Ashtead Group saw its EBIT decline by 17% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Ashtead Group produced sturdy free cash flow equating to 66% 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

Ashtead Group's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to convert EBIT to free cash flow isn't too shabby at all. Looking at all the angles mentioned above, it does seem to us that Ashtead Group is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Ashtead Group is showing 1 warning sign in our investment analysis , 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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