Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu doesn’t care when he says, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital ”. It is natural to consider a company’s balance sheet when considering how risky it is, as debt is often involved when a business collapses. Mostly, Alerion Clean Power SpA (BIT: ARN) is in debt. But the most important question is: what is the risk that this debt creates?
When is debt a problem?
Debt and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is where a company has to issue shares at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
Check out our latest review for Alerion Clean Power
How much debt is Alerion Clean Power?
The graph below, which you can click for more details, shows that Alerion Clean Power had a debt of € 588.2m in December 2020; about the same as the year before. However, he also had € 147.7m in cash, so his net debt is € 440.5m.
How healthy is Alerion Clean Power’s track record?
Zooming in on the latest balance sheet data, we can see that Alerion Clean Power had a liability of € 120.7m within 12 months and a liability of € 616.5m beyond. In return, he had € 147.7 million in cash and € 43.8 million in receivables due within 12 months. Thus, its liabilities exceed the sum of its cash and its (short-term) receivables by € 545.8 million.
This deficit is considerable compared to its market capitalization of € 680.3m, so he suggests shareholders keep an eye on Alerion Clean Power’s use of debt. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to tell us about leverage versus earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). . The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt over EBITDA) and the actual interest charges associated with that debt (with its interest coverage ratio).
Low interest coverage of 1.2 times and an extremely high Net Debt to EBITDA ratio of 7.6 hit our confidence in Alerion Clean Power like a punch. The debt burden here is considerable. The good news is that Alerion Clean Power has increased its EBIT by 32% over the past twelve months. Much like the milk of human kindness, this type of growth increases resilience, making the business more capable of handling debt. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Alerion Clean Power can strengthen its balance sheet over time. So if you are focused on the future you can check out this free report showing analysts’ earnings forecasts.
Finally, while the tax authorities love accounting profits, lenders only accept cash. We must therefore clearly examine whether this EBIT leads to a corresponding free cash flow. Over the past three years, Alerion Clean Power has created a free cash flow of 18% of its EBIT, a performance without interest. For us, the cash conversion that arouses a bit of paranoia is the ability to extinguish debt.
Our point of view
At first glance, Alerion Clean Power’s net debt to EBITDA left us hesitant about the stock, and its interest coverage was no more attractive than the lone empty restaurant on the busiest night of the year. But on the positive side, its EBIT growth rate is a good sign and makes us more optimistic. Once we consider all of the above factors together it seems like Alerion Clean Power’s debt makes it a bit risky. This isn’t necessarily a bad thing, but we would generally feel more comfortable with less leverage. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, Alerion Clean Power has 4 warning signs (and 1 which is a bit disturbing) we think you should know.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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