These 4 Measures Indicate That Arcos Dorados Holdings (NYSE:ARCO) Is Using Debt Extensively

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 the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Our analysis indicates that ARCO is potentially undervalued!

What Is Arcos Dorados Holdings's Net Debt?

The chart below, which you can click on for greater detail, shows that Arcos Dorados Holdings had US$775.4m in debt in June 2022; about the same as the year before. However, because it has a cash reserve of US$289.4m, its net debt is less, at about US$486.0m.

A Look At Arcos Dorados Holdings' Liabilities

The latest balance sheet data shows that Arcos Dorados Holdings had liabilities of US$628.1m due within a year, and liabilities of US$1.56b falling due after that. Offsetting these obligations, it had cash of US$289.4m as well as receivables valued at US$109.1m due within 12 months. So it has liabilities totalling US$1.79b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's US$1.57b 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.

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.

While Arcos Dorados Holdings's low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.1 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Pleasingly, Arcos Dorados Holdings is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 532% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Arcos Dorados Holdings recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Arcos Dorados Holdings's level of total liabilities and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Arcos Dorados Holdings 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. 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 .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.