Does Arcos Dorados Holdings (NYSE:ARCO) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Arcos Dorados Holdings Inc. (NYSE:ARCO) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 Arcos Dorados Holdings

How Much Debt Does Arcos Dorados Holdings Carry?

As you can see below, Arcos Dorados Holdings had US$765.7m of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$139.4m in cash, and so its net debt is US$626.4m.

A Look At Arcos Dorados Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Arcos Dorados Holdings had liabilities of US$816.6m due within 12 months and liabilities of US$1.61b due beyond that. Offsetting these obligations, it had cash of US$139.4m as well as receivables valued at US$180.7m due within 12 months. So its liabilities total US$2.11b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$1.89b, we think shareholders really should watch Arcos Dorados Holdings's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

Arcos Dorados Holdings has net debt of just 1.3 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 10.0 times, which is more than adequate. The good news is that Arcos Dorados Holdings has increased its EBIT by 6.4% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Arcos Dorados Holdings 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. Looking at the most recent three years, Arcos Dorados Holdings recorded free cash flow of 26% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Arcos Dorados Holdings's ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Arcos Dorados Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Arcos Dorados Holdings you should know about.

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.