U.S. Markets open in 9 hrs 25 mins

AeroCentury (NYSEMKT:ACY) Use Of Debt Could Be Considered Risky

Simply Wall St

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 AeroCentury Corp. (NYSEMKT:ACY) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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.

Check out our latest analysis for AeroCentury

What Is AeroCentury's Net Debt?

The image below, which you can click on for greater detail, shows that AeroCentury had debt of US$125.6m at the end of June 2019, a reduction from US$147.6m over a year. On the flip side, it has US$3.36m in cash leading to net debt of about US$122.3m.

AMEX:ACY Historical Debt, August 27th 2019

A Look At AeroCentury's Liabilities

We can see from the most recent balance sheet that AeroCentury had liabilities of US$3.10m falling due within a year, and liabilities of US$164.1m due beyond that. On the other hand, it had cash of US$3.36m and US$22.2m worth of receivables due within a year. So it has liabilities totalling US$141.6m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$10.0m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, AeroCentury would likely require a major re-capitalisation if it had to pay its creditors today.

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).

AeroCentury shareholders face the double whammy of a high net debt to EBITDA ratio (5.5), and fairly weak interest coverage, since EBIT is just 0.91 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, AeroCentury's EBIT was down 21% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if AeroCentury 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, AeroCentury burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, AeroCentury's EBIT growth rate 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. And even its interest cover fails to inspire much confidence. Considering everything we've mentioned above, it's fair to say that AeroCentury is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. Even though AeroCentury 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.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.