David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Avista Corporation (NYSE:AVA) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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 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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Avista Carry?
As you can see below, at the end of June 2019, Avista had US$2.07b of debt, up from US$1.95b a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.
A Look At Avista's Liabilities
According to the last reported balance sheet, Avista had liabilities of US$516.7m due within 12 months, and liabilities of US$3.48b due beyond 12 months. Offsetting this, it had US$17.7m in cash and US$115.5m in receivables that were due within 12 months. So it has liabilities totalling US$3.86b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's US$3.12b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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.
Avista has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 2.5 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Investors should also be troubled by the fact that Avista saw its EBIT drop by 15% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Avista 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, Avista recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
To be frank both Avista's EBIT growth rate and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. We should also note that Integrated Utilities industry companies like Avista commonly do use debt without problems. After considering the datapoints discussed, we think Avista has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given the risks around Avista's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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