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. As with many other companies Aegion Corporation (NASDAQ:AEGN) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Aegion's Debt?
You can click the graphic below for the historical numbers, but it shows that Aegion had US$235.5m of debt in September 2020, down from US$305.6m, one year before. However, it does have US$75.8m in cash offsetting this, leading to net debt of about US$159.7m.
How Healthy Is Aegion's Balance Sheet?
The latest balance sheet data shows that Aegion had liabilities of US$222.1m due within a year, and liabilities of US$290.7m falling due after that. Offsetting this, it had US$75.8m in cash and US$260.4m in receivables that were due within 12 months. So it has liabilities totalling US$176.7m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Aegion has a market capitalization of US$650.8m, 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). 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).
Aegion's net debt is sitting at a very reasonable 1.7 times its EBITDA, while its EBIT covered its interest expense just 3.9 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. One way Aegion could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 13%, as it did over the last year. 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 Aegion'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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Aegion generated free cash flow amounting to a very robust 84% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Aegion's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its interest cover. Looking at all the aforementioned factors together, it strikes us that Aegion can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Aegion , and understanding them should be part of your investment process.
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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