Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that ARC Resources Ltd. (TSE:ARX) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is ARC Resources's Debt?
You can click the graphic below for the historical numbers, but it shows that ARC Resources had CA$812.3m of debt in June 2019, down from CA$892.9m, one year before. However, it does have CA$50.7m in cash offsetting this, leading to net debt of about CA$761.6m.
How Strong Is ARC Resources's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that ARC Resources had liabilities of CA$269.2m due within 12 months and liabilities of CA$2.00b due beyond that. Offsetting this, it had CA$50.7m in cash and CA$101.9m in receivables that were due within 12 months. So its liabilities total CA$2.12b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of CA$2.09b, we think shareholders really should watch ARC Resources's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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.
With net debt sitting at just 0.94 times EBITDA, ARC Resources is arguably pretty conservatively geared. And it boasts interest cover of 7.9 times, which is more than adequate. In addition to that, we're happy to report that ARC Resources has boosted its EBIT by 50%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if ARC Resources 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, ARC Resources recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
Neither ARC Resources's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that ARC Resources is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if ARC Resources insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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