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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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that ALLETE, Inc. (NYSE:ALE) does use debt in its business. But the real question is whether this debt is making the company risky.
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
What Is ALLETE’s Net Debt?
As you can see below, ALLETE had US$1.54b of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$353.3m, its net debt is less, at about US$1.19b.
How Healthy Is ALLETE’s Balance Sheet?
We can see from the most recent balance sheet that ALLETE had liabilities of US$322.4m falling due within a year, and liabilities of US$2.70b due beyond that. Offsetting these obligations, it had cash of US$353.3m as well as receivables valued at US$98.9m due within 12 months. So its liabilities total US$2.57b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because ALLETE is worth US$4.48b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Either way, since ALLETE does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
ALLETE has a debt to EBITDA ratio of 2.94 and its EBIT covered its interest expense 3.11 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Even more troubling is the fact that ALLETE actually let its EBIT decrease by 3.0% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine ALLETE’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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, ALLETE’s free cash flow amounted to 50% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
ALLETE’s interest cover was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its conversion of EBIT to free cash flow is relatively strong. We should also note that Electric Utilities industry companies like ALLETE commonly do use debt without problems. When we consider all the factors discussed, it seems to us that ALLETE is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. Given our hesitation about the stock, it would be good to know if ALLETE insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.