These 4 Measures Indicate That Alerion Clean Power (BIT:ARN) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Alerion Clean Power S.p.A. (BIT:ARN) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Alerion Clean Power

What Is Alerion Clean Power's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Alerion Clean Power had €595.9m of debt, an increase on €345.8m, over one year. On the flip side, it has €149.6m in cash leading to net debt of about €446.3m.

How Strong Is Alerion Clean Power's Balance Sheet?

According to the last reported balance sheet, Alerion Clean Power had liabilities of €82.2m due within 12 months, and liabilities of €667.3m due beyond 12 months. Offsetting these obligations, it had cash of €149.6m as well as receivables valued at €41.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €558.5m.

When you consider that this deficiency exceeds the company's €406.5m market capitalization, you might well be inclined to review the balance sheet intently. 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.

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.

Alerion Clean Power shareholders face the double whammy of a high net debt to EBITDA ratio (7.1), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. The debt burden here is substantial. Looking on the bright side, Alerion Clean Power boosted its EBIT by a silky 100% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Alerion Clean Power will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, Alerion Clean Power recorded free cash flow worth a fulsome 96% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

We feel some trepidation about Alerion Clean Power's difficulty net debt to EBITDA, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and EBIT growth rate give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Alerion Clean Power is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 3 warning signs for Alerion Clean Power you should be aware of, and 1 of them shouldn't be ignored.

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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