Here's Why AAR (NYSE:AIR) Can Manage Its Debt Responsibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 AAR Corp. (NYSE:AIR) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for AAR

What Is AAR's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of May 2023 AAR had US$269.7m of debt, an increase on US$98.9m, over one year. However, because it has a cash reserve of US$68.4m, its net debt is less, at about US$201.3m.

How Strong Is AAR's Balance Sheet?

According to the last reported balance sheet, AAR had liabilities of US$351.5m due within 12 months, and liabilities of US$382.5m due beyond 12 months. Offsetting these obligations, it had cash of US$68.4m as well as receivables valued at US$335.0m due within 12 months. So it has liabilities totalling US$330.6m more than its cash and near-term receivables, combined.

Since publicly traded AAR shares are worth a total of US$2.10b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

AAR's net debt is only 1.2 times its EBITDA. And its EBIT easily covers its interest expense, being 12.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, AAR grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if AAR can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the most recent three years, AAR recorded free cash flow worth 50% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

AAR'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 the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think AAR's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that AAR insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.