Is ACEA (BIT:ACE) Using Too Much Debt?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, ACEA S.p.A. (BIT:ACE) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for ACEA

How Much Debt Does ACEA Carry?

As you can see below, at the end of March 2021, ACEA had €5.29b of debt, up from €4.33b a year ago. Click the image for more detail. However, it also had €1.28b in cash, and so its net debt is €4.01b.

How Strong Is ACEA's Balance Sheet?

We can see from the most recent balance sheet that ACEA had liabilities of €2.49b falling due within a year, and liabilities of €5.65b due beyond that. Offsetting these obligations, it had cash of €1.28b as well as receivables valued at €1.51b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €5.36b.

Given this deficit is actually higher than the company's market capitalization of €4.25b, we think shareholders really should watch ACEA's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). 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).

ACEA's debt is 4.4 times its EBITDA, and its EBIT cover its interest expense 5.4 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. If ACEA can keep growing EBIT at last year's rate of 12% over the last year, then it will find its debt load easier to manage. 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, ACEA basically broke even on a free cash flow basis. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.

Our View

To be frank both ACEA's conversion of EBIT to free cash flow 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 growing its EBIT; that's encouraging. It's also worth noting that ACEA is in the Integrated Utilities industry, which is often considered to be quite defensive. Overall, we think it's fair to say that ACEA has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For example ACEA has 2 warning signs (and 1 which is concerning) we think you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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