Avation (LON:AVAP) Takes On Some Risk With Its Use Of Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Avation PLC (LON:AVAP) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Avation

How Much Debt Does Avation Carry?

You can click the graphic below for the historical numbers, but it shows that Avation had US$779.0m of debt in December 2022, down from US$893.7m, one year before. However, it also had US$122.1m in cash, and so its net debt is US$656.9m.

How Strong Is Avation's Balance Sheet?

According to the last reported balance sheet, Avation had liabilities of US$118.3m due within 12 months, and liabilities of US$831.2m due beyond 12 months. On the other hand, it had cash of US$122.1m and US$25.6m worth of receivables due within a year. So its liabilities total US$801.8m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$120.1m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Avation would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Avation shareholders face the double whammy of a high net debt to EBITDA ratio (7.5), and fairly weak interest coverage, since EBIT is just 0.97 times the interest expense. This means we'd consider it to have a heavy debt load. On a slightly more positive note, Avation grew its EBIT at 10% over the last year, further increasing its ability to manage debt. 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 Avation 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Avation actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both Avation's interest cover and its track record of staying on top of its total liabilities 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. Looking at the bigger picture, it seems clear to us that Avation's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. Case in point: We've spotted 4 warning signs for Avation you should be aware of, and 2 of them shouldn't be ignored.

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. 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.