Here's Why ACEA (BIT:ACE) Is Weighed Down By Its Debt Load

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, ACEA S.p.A. (BIT:ACE) does carry debt. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for ACEA

What Is ACEA's Debt?

The image below, which you can click on for greater detail, shows that at March 2023 ACEA had debt of €5.69b, up from €5.05b in one year. On the flip side, it has €670.9m in cash leading to net debt of about €5.02b.

How Strong Is ACEA's Balance Sheet?

According to the last reported balance sheet, ACEA had liabilities of €2.96b due within 12 months, and liabilities of €6.21b due beyond 12 months. Offsetting these obligations, it had cash of €670.9m as well as receivables valued at €1.38b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €7.13b.

The deficiency here weighs heavily on the €2.92b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, ACEA 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

ACEA's debt is 4.7 times its EBITDA, and its EBIT cover its interest expense 5.3 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Sadly, ACEA's EBIT actually dropped 6.5% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 ACEA'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, ACEA saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, ACEA's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. We should also note that Integrated Utilities industry companies like ACEA commonly do use debt without problems. After considering the datapoints discussed, we think ACEA has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 ACEA is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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.