Here's Why Archrock (NYSE:AROC) Has A Meaningful Debt Burden

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 can see that Archrock, Inc. (NYSE:AROC) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Archrock

How Much Debt Does Archrock Carry?

As you can see below, at the end of September 2023, Archrock had US$1.60b of debt, up from US$1.50b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Archrock's Balance Sheet?

We can see from the most recent balance sheet that Archrock had liabilities of US$159.4m falling due within a year, and liabilities of US$1.65b due beyond that. Offsetting this, it had US$482.0k in cash and US$129.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.68b.

This deficit is considerable relative to its market capitalization of US$2.39b, so it does suggest shareholders should keep an eye on Archrock's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Archrock's net debt to EBITDA ratio of 4.1, we think its super-low interest cover of 2.1 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Looking on the bright side, Archrock boosted its EBIT by a silky 62% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Archrock'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Archrock's free cash flow amounted to 27% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Archrock's interest cover and net debt to EBITDA definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Archrock's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Archrock is showing 3 warning signs in our investment analysis , and 2 of those make us uncomfortable...

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.