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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that AerCap Holdings N.V. (NYSE:AER) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is AerCap Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2020 AerCap Holdings had debt of US$31.3b, up from US$29.3b in one year. However, because it has a cash reserve of US$3.25b, its net debt is less, at about US$28.0b.
A Look At AerCap Holdings' Liabilities
The latest balance sheet data shows that AerCap Holdings had liabilities of US$2.47b due within a year, and liabilities of US$33.1b falling due after that. Offsetting this, it had US$3.25b in cash and US$1.96b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$30.3b.
This deficit casts a shadow over the US$5.51b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, AerCap Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 2.0 times and a disturbingly high net debt to EBITDA ratio of 11.2 hit our confidence in AerCap Holdings like a one-two punch to the gut. The debt burden here is substantial. More concerning, AerCap Holdings saw its EBIT drop by 5.0% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine AerCap Holdings'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, AerCap Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both AerCap Holdings's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. Considering all the factors previously mentioned, we think that AerCap Holdings really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. Like risks, for instance. Every company has them, and we've spotted 2 warning signs for AerCap Holdings (of which 1 can't be ignored!) 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.
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AerCap Holdings N.V. engages in the lease, financing, sale, and management of commercial flight equipment in China, Hong Kong, Macau, the United States, Ireland, and internationally.
Moderate growth potential and slightly overvalued.