Stock Analysis

Allison Transmission Holdings (NYSE:ALSN) Seems To Use Debt Quite Sensibly

NYSE:ALSN
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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 note that Allison Transmission Holdings, Inc. (NYSE:ALSN) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. 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. 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.

See our latest analysis for Allison Transmission Holdings

How Much Debt Does Allison Transmission Holdings Carry?

The chart below, which you can click on for greater detail, shows that Allison Transmission Holdings had US$2.52b in debt in March 2022; about the same as the year before. However, because it has a cash reserve of US$145.0m, its net debt is less, at about US$2.37b.

debt-equity-history-analysis
NYSE:ALSN Debt to Equity History July 12th 2022

A Look At Allison Transmission Holdings' Liabilities

We can see from the most recent balance sheet that Allison Transmission Holdings had liabilities of US$489.0m falling due within a year, and liabilities of US$3.36b due beyond that. On the other hand, it had cash of US$145.0m and US$343.0m worth of receivables due within a year. So its liabilities total US$3.36b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of US$3.60b, so it does suggest shareholders should keep an eye on Allison Transmission Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Allison Transmission Holdings's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 6.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, Allison Transmission Holdings grew its EBIT by 33% over the last twelve months, and that growth will make it easier to handle its debt. 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 Allison Transmission 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Allison Transmission Holdings produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Allison Transmission Holdings's EBIT growth rate was a real positive on this analysis, as was its conversion of EBIT to free cash flow. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. Considering this range of data points, we think Allison Transmission Holdings is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example, we've discovered 2 warning signs for Allison Transmission Holdings (1 is a bit concerning!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

Valuation is complex, but we're helping make it simple.

Find out whether Allison Transmission Holdings is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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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.