These 4 Measures Indicate That Archer (OB:ARCH) Is Using Debt In A Risky Way

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. We can see that Archer Limited (OB:ARCH) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Archer

What Is Archer's Net Debt?

The chart below, which you can click on for greater detail, shows that Archer had US$550.7m in debt in December 2021; about the same as the year before. However, it does have US$50.7m in cash offsetting this, leading to net debt of about US$500.0m.

How Healthy Is Archer's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Archer had liabilities of US$214.2m due within 12 months and liabilities of US$548.0m due beyond that. Offsetting these obligations, it had cash of US$50.7m as well as receivables valued at US$125.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$585.9m.

This deficit casts a shadow over the US$51.6m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Archer 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). 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).

Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 5.9 hit our confidence in Archer like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Archer saw its EBIT tank 39% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Archer'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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Archer's free cash flow amounted to 42% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Archer's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. We think the chances that Archer has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Archer that you should be aware of.

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.