These 4 Measures Indicate That Alliance Data Systems (NYSE:ADS) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Alliance Data Systems Corporation (NYSE:ADS) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

View our latest analysis for Alliance Data Systems

What Is Alliance Data Systems's Debt?

The image below, which you can click on for greater detail, shows that Alliance Data Systems had debt of US$16.6b at the end of March 2021, a reduction from US$20.8b over a year. On the flip side, it has US$2.86b in cash leading to net debt of about US$13.7b.

How Healthy Is Alliance Data Systems' Balance Sheet?

According to the last reported balance sheet, Alliance Data Systems had liabilities of US$10.7b due within 12 months, and liabilities of US$8.66b due beyond 12 months. Offsetting these obligations, it had cash of US$2.86b as well as receivables valued at US$351.9m due within 12 months. So its liabilities total US$16.2b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$5.41b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Alliance Data Systems would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Alliance Data Systems's debt to EBITDA ratio of 13.0 suggests a heavy debt load, its interest coverage of 8.3 implies it services that debt with ease. Overall we'd say it seems likely the company is carrying a fairly heavy swag of debt. Alliance Data Systems grew its EBIT by 7.3% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Alliance Data Systems can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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 three years, Alliance Data Systems actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, Alliance Data Systems's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Alliance Data Systems's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Alliance Data Systems (at least 2 which are a bit unpleasant) , 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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