Does AZEK (NYSE:AZEK) Have A Healthy Balance Sheet?

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.' 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. Importantly, The AZEK Company Inc. (NYSE:AZEK) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for AZEK

What Is AZEK's Debt?

As you can see below, AZEK had US$465.0m of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$66.1m in cash leading to net debt of about US$398.9m.

How Healthy Is AZEK's Balance Sheet?

We can see from the most recent balance sheet that AZEK had liabilities of US$162.5m falling due within a year, and liabilities of US$601.4m due beyond that. Offsetting this, it had US$66.1m in cash and US$63.1m in receivables that were due within 12 months. So it has liabilities totalling US$634.8m more than its cash and near-term receivables, combined.

Given AZEK has a market capitalization of US$4.77b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

AZEK's net debt of 1.6 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.1 times interest expense) certainly does not do anything to dispel this impression. It was also good to see that despite losing money on the EBIT line last year, AZEK turned things around in the last 12 months, delivering and EBIT of US$149m. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine AZEK's ability to maintain a healthy balance sheet going forward. 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, AZEK burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

AZEK's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its interest cover is relatively strong. Looking at all the angles mentioned above, it does seem to us that AZEK is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - AZEK has 2 warning signs we think you should be aware of.

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.

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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.