The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Air Asia Co., Ltd. (TPE:2630) makes use of debt. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Air Asia
How Much Debt Does Air Asia Carry?
The image below, which you can click on for greater detail, shows that at September 2020 Air Asia had debt of NT$2.30b, up from NT$2.16b in one year. However, it also had NT$377.8m in cash, and so its net debt is NT$1.92b.
How Healthy Is Air Asia's Balance Sheet?
We can see from the most recent balance sheet that Air Asia had liabilities of NT$2.32b falling due within a year, and liabilities of NT$820.9m due beyond that. Offsetting these obligations, it had cash of NT$377.8m as well as receivables valued at NT$1.97b due within 12 months. So its liabilities total NT$800.5m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Air Asia has a market capitalization of NT$2.26b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 0.75 times and a disturbingly high net debt to EBITDA ratio of 21.9 hit our confidence in Air Asia like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Air Asia saw its EBIT tank 81% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is Air Asia's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, Air Asia 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.
Our View
On the face of it, Air Asia's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. Taking into account all the aforementioned factors, it looks like Air Asia has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Air Asia is showing 6 warning signs in our investment analysis , and 2 of those can't be ignored...
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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About TWSE:2630
Air Asia
Operates as an aircraft maintenance company in Taiwan, rest of Asia, and internationally.
Solid track record with adequate balance sheet.