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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that The AES Corporation (NYSE:AES) does use debt in its business. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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.
What Is AES’s Net Debt?
The chart below, which you can click on for greater detail, shows that AES had US$19.7b in debt in March 2019; about the same as the year before. However, it does have US$1.80b in cash offsetting this, leading to net debt of about US$17.9b.
A Look At AES’s Liabilities
The latest balance sheet data shows that AES had liabilities of US$4.36b due within a year, and liabilities of US$23.4b falling due after that. Offsetting these obligations, it had cash of US$1.80b as well as receivables valued at US$1.56b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$24.4b.
The deficiency here weighs heavily on the US$11.2b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt After all, AES would likely require a major re-capitalisation if it had to pay its creditors today.
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.
With a net debt to EBITDA ratio of 5.4, it’s fair to say AES does have a significant amount of debt. However, its interest coverage of 3.2 is reasonably strong, which is a good sign. Even more troubling is the fact that AES actually let its EBIT decrease by 2.5% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill — a lot of effort for not much advancement. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if AES 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, AES created free cash flow amounting to 17% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
To be frank both AES’s net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn’t such a worry. After considering the datapoints discussed, we think AES has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. Given our concerns about AES’s debt levels, it seems only prudent to check if insiders have been ditching the stock.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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