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. 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 Alamo Group Inc. (NYSE:ALG) 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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Alamo Group's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Alamo Group had debt of US$166.0m, up from US$119.0m in one year. On the flip side, it has US$48.2m in cash leading to net debt of about US$117.8m.
How Strong Is Alamo Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Alamo Group had liabilities of US$117.2m due within 12 months and liabilities of US$206.6m due beyond that. Offsetting these obligations, it had cash of US$48.2m as well as receivables valued at US$275.3m due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
Having regard to Alamo Group's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$1.37b company is struggling for cash, we still think it's worth monitoring 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.
Alamo Group's net debt is only 0.90 times its EBITDA. And its EBIT covers its interest expense a whopping 19.6 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Alamo Group grew its EBIT by 8.6% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Alamo Group'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Alamo Group recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Alamo Group's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. When we consider the range of factors above, it looks like Alamo Group is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Alamo Group insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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