The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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 note that Alliance Aviation Services Limited (ASX:AQZ) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
What Is Alliance Aviation Services's Net Debt?
The image below, which you can click on for greater detail, shows that Alliance Aviation Services had debt of AU$60.1m at the end of June 2019, a reduction from AU$65.3m over a year. However, it does have AU$9.61m in cash offsetting this, leading to net debt of about AU$50.4m.
How Healthy Is Alliance Aviation Services's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Alliance Aviation Services had liabilities of AU$55.7m due within 12 months and liabilities of AU$76.9m due beyond that. Offsetting this, it had AU$9.61m in cash and AU$36.7m in receivables that were due within 12 months. So its liabilities total AU$86.3m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Alliance Aviation Services is worth AU$318.5m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
Alliance Aviation Services has a low net debt to EBITDA ratio of only 0.75. And its EBIT easily covers its interest expense, being 13.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Alliance Aviation Services grew its EBIT by 23% in the last year, and that should make it easier to pay down debt, going forward. 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 Alliance Aviation Services 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Alliance Aviation Services recorded free cash flow worth 53% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that Alliance Aviation Services's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Taking all this data into account, it seems to us that Alliance Aviation Services takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Alliance Aviation Services insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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