Does Arconic (NYSE:ARNC) Have A Healthy Balance Sheet?

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.' 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 can see that Arconic Corporation (NYSE:ARNC) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Arconic

What Is Arconic's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Arconic had US$1.59b of debt, an increase on US$1.28b, over one year. However, because it has a cash reserve of US$540.0m, its net debt is less, at about US$1.05b.

How Strong Is Arconic's Balance Sheet?

We can see from the most recent balance sheet that Arconic had liabilities of US$1.85b falling due within a year, and liabilities of US$3.07b due beyond that. Offsetting these obligations, it had cash of US$540.0m as well as receivables valued at US$1.02b due within 12 months. So it has liabilities totalling US$3.36b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$3.56b, so it does suggest shareholders should keep an eye on Arconic'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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Arconic has net debt worth 2.1 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 2.8 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Arconic grew its EBIT by 3.6% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Arconic'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Arconic saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Arconic's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its EBIT growth rate is not so bad. We're quite clear that we consider Arconic to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Arconic that you should be aware of.

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.

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.

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