Here's Why Arcos Dorados Holdings (NYSE:ARCO) Can Manage Its Debt Responsibly

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.' 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 is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Arcos Dorados Holdings

How Much Debt Does Arcos Dorados Holdings Carry?

The chart below, which you can click on for greater detail, shows that Arcos Dorados Holdings had US$765.2m in debt in September 2022; about the same as the year before. However, it does have US$319.1m in cash offsetting this, leading to net debt of about US$446.1m.

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$684.1m due within 12 months and liabilities of US$1.52b due beyond that. Offsetting this, it had US$319.1m in cash and US$113.8m in receivables that were due within 12 months. So it has liabilities totalling US$1.77b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's US$1.71b market capitalization, you might well be inclined to review the balance sheet intently. 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.

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.

Looking at its net debt to EBITDA of 1.2 and interest cover of 5.5 times, it seems to us that Arcos Dorados Holdings is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Pleasingly, Arcos Dorados Holdings is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 177% gain in the last twelve months. 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 Arcos Dorados Holdings'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, Arcos Dorados Holdings generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Arcos Dorados Holdings's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its level of total liabilities has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Arcos Dorados Holdings can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. For example - Arcos Dorados Holdings has 2 warning signs we think you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.