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, American Airlines Group Inc. (NASDAQ:AAL) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is American Airlines Group's Debt?
As you can see below, American Airlines Group had US$24.6b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has US$5.41b in cash leading to net debt of about US$19.2b.
How Strong Is American Airlines Group's Balance Sheet?
We can see from the most recent balance sheet that American Airlines Group had liabilities of US$20.1b falling due within a year, and liabilities of US$41.9b due beyond that. Offsetting this, it had US$5.41b in cash and US$1.94b in receivables that were due within 12 months. So it has liabilities totalling US$54.6b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$12.3b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt After all, American Airlines Group would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
American Airlines Group has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 3.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Investors should also be troubled by the fact that American Airlines Group saw its EBIT drop by 16% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine American Airlines Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, American Airlines Group 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.
On the face of it, American Airlines Group's conversion of EBIT to free cash flow 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 furthermore, its net debt to EBITDA also fails to instill confidence. Considering all the factors previously mentioned, we think that American Airlines Group really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. Given the risks around American Airlines Group's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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.
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