Stock Analysis

These 4 Measures Indicate That Alcoa (NYSE:AA) Is Using Debt Reasonably Well

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NYSE:AA
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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Alcoa Corporation (NYSE:AA) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

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What Is Alcoa's Debt?

The image below, which you can click on for greater detail, shows that at June 2021 Alcoa had debt of US$2.22b, up from US$1.80b in one year. However, because it has a cash reserve of US$1.65b, its net debt is less, at about US$565.0m.

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NYSE:AA Debt to Equity History September 30th 2021

A Look At Alcoa's Liabilities

The latest balance sheet data shows that Alcoa had liabilities of US$2.67b due within a year, and liabilities of US$6.35b falling due after that. Offsetting this, it had US$1.65b in cash and US$744.0m in receivables that were due within 12 months. So it has liabilities totalling US$6.62b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$9.45b, so it does suggest shareholders should keep an eye on Alcoa'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.

While Alcoa's low debt to EBITDA ratio of 0.33 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.5 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, Alcoa's EBIT launched higher than Elon Musk, gaining a whopping 177% on last year. 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 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. Looking at the most recent three years, Alcoa recorded free cash flow of 24% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Both Alcoa's ability to to grow its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. Considering this range of data points, we think Alcoa 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Alcoa has 4 warning signs (and 2 which don't sit too well with us) we think you should know about.

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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