Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Auckland International Airport Limited (NZSE:AIA) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. 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 think about a company's use of debt, we first look at cash and debt together.
What Is Auckland International Airport's Net Debt?
As you can see below, at the end of June 2023, Auckland International Airport had NZ$1.84b of debt, up from NZ$1.49b a year ago. Click the image for more detail. However, it also had NZ$107.7m in cash, and so its net debt is NZ$1.73b.
How Strong Is Auckland International Airport's Balance Sheet?
We can see from the most recent balance sheet that Auckland International Airport had liabilities of NZ$596.2m falling due within a year, and liabilities of NZ$1.86b due beyond that. Offsetting this, it had NZ$107.7m in cash and NZ$44.3m in receivables that were due within 12 months. So it has liabilities totalling NZ$2.30b more than its cash and near-term receivables, combined.
Given Auckland International Airport has a market capitalization of NZ$11.6b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Auckland International Airport's debt is 4.3 times its EBITDA, and its EBIT cover its interest expense 4.3 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. The silver lining is that Auckland International Airport grew its EBIT by 573% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Auckland International Airport 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Auckland International Airport saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Based on what we've seen Auckland International Airport is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its EBIT growth rate. It's also worth noting that Auckland International Airport is in the Infrastructure industry, which is often considered to be quite defensive. Looking at all this data makes us feel a little cautious about Auckland International Airport's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Auckland International Airport you should know about.
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.
Valuation is complex, but we're helping make it simple.
Find out whether Auckland International Airport is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.View the Free Analysis
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.