Is Arcos Dorados Holdings (NYSE:ARCO) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, Arcos Dorados Holdings Inc. (NYSE:ARCO) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Arcos Dorados Holdings

What Is Arcos Dorados Holdings's Debt?

As you can see below, Arcos Dorados Holdings had US$758.9m of debt, at March 2023, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$263.8m, its net debt is less, at about US$495.1m.

How Healthy Is Arcos Dorados Holdings' Balance Sheet?

According to the last reported balance sheet, Arcos Dorados Holdings had liabilities of US$757.8m due within 12 months, and liabilities of US$1.59b due beyond 12 months. On the other hand, it had cash of US$263.8m and US$116.9m worth of receivables due within a year. So its liabilities total US$1.97b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's US$1.92b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). 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 1.2 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 7.4 times the interest expense over the last year. In addition to that, we're happy to report that Arcos Dorados Holdings has boosted its EBIT by 52%, thus reducing the spectre of future debt repayments. 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 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 always check how much of that EBIT is translated into free cash flow. Over the most recent two years, Arcos Dorados Holdings recorded free cash flow worth 62% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

When it comes to the balance sheet, the standout positive for Arcos Dorados Holdings was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. Considering this range of data points, we think Arcos Dorados 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. To that end, you should be aware of the 2 warning signs we've spotted with Arcos Dorados Holdings .

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.