Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, ACEA S.p.A. (BIT:ACE) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is ACEA's Net Debt?
The image below, which you can click on for greater detail, shows that ACEA had debt of €3.74b at the end of March 2019, a reduction from €4.27b over a year. However, it does have €1.04b in cash offsetting this, leading to net debt of about €2.71b.
How Strong Is ACEA's Balance Sheet?
We can see from the most recent balance sheet that ACEA had liabilities of €2.64b falling due within a year, and liabilities of €3.63b due beyond that. Offsetting these obligations, it had cash of €1.04b as well as receivables valued at €1.04b due within 12 months. So its liabilities total €4.19b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's €3.60b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
ACEA's debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 5.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We note that ACEA grew its EBIT by 26% in the last year, and that should make it easier to pay down debt, going forward. 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 ACEA 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, ACEA reported free cash flow worth 8.6% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Neither ACEA's ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. It's also worth noting that ACEA is in the Integrated Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think ACEA's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Given ACEA has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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