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.' 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 note that Aptiv PLC (NYSE:APTV) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
What Is Aptiv's Net Debt?
The image below, which you can click on for greater detail, shows that Aptiv had debt of US$4.00b at the end of March 2021, a reduction from US$6.20b over a year. However, it also had US$2.83b in cash, and so its net debt is US$1.17b.
How Strong Is Aptiv's Balance Sheet?
We can see from the most recent balance sheet that Aptiv had liabilities of US$3.96b falling due within a year, and liabilities of US$5.24b due beyond that. Offsetting this, it had US$2.83b in cash and US$3.22b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.15b.
Since publicly traded Aptiv shares are worth a very impressive total of US$39.8b, it seems unlikely that this level of liabilities would be a major 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). 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).
While Aptiv's low debt to EBITDA ratio of 0.65 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.7 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. The modesty of its debt load may become crucial for Aptiv if management cannot prevent a repeat of the 20% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Aptiv's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Aptiv produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Based on what we've seen Aptiv is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. Considering this range of data points, we think Aptiv is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Aptiv has 2 warning signs we think you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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