Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We can see that AeroVironment, Inc. (NASDAQ:AVAV) does use debt in its business. But the real question is whether this debt is making the company risky.
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is AeroVironment's Net Debt?
The image below, which you can click on for greater detail, shows that at April 2021 AeroVironment had debt of US$197.5m, up from none in one year. However, it does have US$180.7m in cash offsetting this, leading to net debt of about US$16.8m.
How Healthy Is AeroVironment's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that AeroVironment had liabilities of US$96.2m due within 12 months and liabilities of US$220.3m due beyond that. On the other hand, it had cash of US$180.7m and US$134.3m worth of receivables due within a year. So these liquid assets roughly match the total liabilities.
Having regard to AeroVironment's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$2.32b company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, AeroVironment has virtually no net debt, so it's fair to say it does not have a heavy debt load!
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).
AeroVironment has a low net debt to EBITDA ratio of only 0.24. And its EBIT covers its interest expense a whopping 81.4 times over. So we're pretty relaxed about its super-conservative use of debt. The good news is that AeroVironment has increased its EBIT by 8.6% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if AeroVironment 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, while the tax-man may adore accounting profits, lenders only accept 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, AeroVironment produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
AeroVironment's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Zooming out, AeroVironment seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. To that end, you should be aware of the 3 warning signs we've spotted with AeroVironment .
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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