Stock Analysis

Alcoa (NYSE:AA) Has A Pretty Healthy Balance Sheet

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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Alcoa Corporation (NYSE:AA) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. 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.

See our latest analysis for Alcoa

What Is Alcoa's Net Debt?

The image below, which you can click on for greater detail, shows that Alcoa had debt of US$1.80b at the end of December 2021, a reduction from US$2.54b over a year. But on the other hand it also has US$1.81b in cash, leading to a US$12.0m net cash position.

NYSE:AA Debt to Equity History March 14th 2022

How Strong Is Alcoa's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Alcoa had liabilities of US$3.22b due within 12 months and liabilities of US$5.52b due beyond that. Offsetting these obligations, it had cash of US$1.81b as well as receivables valued at US$884.0m due within 12 months. So its liabilities total US$6.04b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Alcoa has a huge market capitalization of US$14.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Alcoa also has more cash than debt, so we're pretty confident it can manage its debt safely.

Better yet, Alcoa grew its EBIT by 461% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Alcoa'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Alcoa may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Alcoa recorded free cash flow of 27% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While Alcoa does have more liabilities than liquid assets, it also has net cash of US$12.0m. And we liked the look of last year's 461% year-on-year EBIT growth. So we don't have any problem with Alcoa's use of debt. 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. For example, we've discovered 3 warning signs for Alcoa that you should be aware of before investing here.

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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