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. 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. We can see that Atlantica Yield plc (NASDAQ:AY) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Atlantica Yield Carry?
The image below, which you can click on for greater detail, shows that Atlantica Yield had debt of US$5.90b at the end of September 2019, a reduction from US$6.18b over a year. On the flip side, it has US$904.1m in cash leading to net debt of about US$5.00b.
How Healthy Is Atlantica Yield's Balance Sheet?
According to the last reported balance sheet, Atlantica Yield had liabilities of US$1.01b due within 12 months, and liabilities of US$7.03b due beyond 12 months. On the other hand, it had cash of US$904.1m and US$319.6m worth of receivables due within a year. So its liabilities total US$6.82b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$2.49b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, Atlantica Yield would probably need a major re-capitalization if its creditors were to demand repayment.
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). 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).
Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 6.5 hit our confidence in Atlantica Yield like a one-two punch to the gut. The debt burden here is substantial. The good news is that Atlantica Yield improved its EBIT by 6.9% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Atlantica Yield can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Atlantica Yield recorded free cash flow worth a fulsome 98% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
On the face of it, Atlantica Yield's interest cover 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. Overall, we think it's fair to say that Atlantica Yield has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Even though Atlantica Yield lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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