We think ALD (EPA:ALD) is taking risks with its debt

Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We can see that ALD S.A. (EPA:ALD) uses debt in its business. But the real question is whether this debt makes the business risky.

Why is debt risky?

Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

Check out our latest analysis for ALD

What is ALD’s debt?

You can click on the graph below for historical figures, but it shows that in December 2021, ALD had 18.5 billion euros in debt, an increase from 17.7 billion euros, on a year. And he doesn’t have a lot of cash, so his net debt is about the same.

ENXTPA: ALD Debt to Equity History February 23, 2022

A look at ALD’s responsibilities

We can see from the most recent balance sheet that ALD had liabilities of 8.36 billion euros maturing in one year and liabilities of 22.1 billion euros maturing beyond. In return, it had €153.0 million in cash and €777.0 million in receivables due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by €29.6 billion.

This deficit casts a shadow over the 5.54 billion euro company, like a colossus towering over mere mortals. We would therefore be watching his balance sheet closely, no doubt. After all, ALD would probably need a major recapitalization if it had to pay its creditors today.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without amortization and depreciation expense.

Strangely, ALD has a sky-high EBITDA ratio of 16.0, implying high debt, but high interest coverage of 1k. This means that unless the company has access to very cheap debt, these interest charges will likely increase in the future. Importantly, ALD has increased its EBIT by 83% over the last twelve months, and this growth will make it easier to manage its debt. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine ALD’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, a company can only repay its debts with cold hard cash, not with book profits. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Looking back over the past three years, ALD has actually recorded a cash outflow, overall. Debt is much riskier for companies with unreliable free cash flow, so shareholders must hope that past spending will produce free cash flow in the future.

Our point of view

To be frank, ALD’s net debt to EBITDA ratio and track record of keeping total liabilities under control makes us rather uncomfortable with its debt levels. But at least it’s decent enough to cover its interest costs with its EBIT; it’s encouraging. Overall, we think it’s fair to say that ALD has enough debt that there are real risks around the balance sheet. If all goes well, this should boost returns, but on the other hand, the risk of permanent capital loss is increased by debt. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. We have identified 3 warning signs with ALD (at least 2 of which we don’t like too much), and understanding them should be part of your investment process.

If you are interested in investing in businesses that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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John A. Bogar