David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We note that Antero Midstream Corporation (NYSE:AM) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Antero Midstream's Net Debt?
The chart below, which you can click on for greater detail, shows that Antero Midstream had US$3.10b in debt in March 2021; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.
How Healthy Is Antero Midstream's Balance Sheet?
We can see from the most recent balance sheet that Antero Midstream had liabilities of US$79.8m falling due within a year, and liabilities of US$3.11b due beyond that. On the other hand, it had cash of US$261.0k and US$89.9m worth of receivables due within a year. So its liabilities total US$3.10b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of US$4.77b, so it does suggest shareholders should keep an eye on Antero Midstream's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Antero Midstream has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 3.6 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Fortunately, Antero Midstream grew its EBIT by 9.3% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Antero Midstream'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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, Antero Midstream recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
When it comes to the balance sheet, the standout positive for Antero Midstream was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For example, its net debt to EBITDA makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Antero Midstream's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. We've identified 2 warning signs with Antero Midstream (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.
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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