Algonquin Power & Utilities (TSE: AQN) Recourse to debt could be considered risky
Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We notice that Algonquin Power & Utilities Corp. (TSE: AQN) has debt on its balance sheet. But should shareholders be concerned about its use of debt?
What risk does debt entail?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) event is when a company has to issue stock 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. When we think of a business’s use of debt, we first look at cash flow and debt together.
See our latest analysis for Algonquin Power & Utilities
What is the debt of Algonquin Power & Utilities?
As you can see below, at the end of March 2021, Algonquin Power & Utilities was in debt of US $ 6.44 billion, up from US $ 4.33 billion a year ago. Click on the image for more details. On the other hand, it has $ 142.5 million in cash, resulting in net debt of around $ 6.30 billion.
How healthy is Algonquin Power & Utilities’ balance sheet?
According to the latest published balance sheet, Algonquin Power & Utilities had liabilities of US $ 1.40 billion due within 12 months and liabilities of US $ 7.60 billion due beyond 12 months. On the other hand, it had US $ 142.5 million in cash and US $ 366.3 million in receivables due within one year. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by $ 8.50 billion.
This is a mountain of leverage compared to its market cap of US $ 9.51 billion. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.
We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Low interest coverage of 1.8 times and an unusually high net debt to EBITDA ratio of 9.6 shook our confidence in Algonquin Power & Utilities like a punch in the stomach. The debt burden here is considerable. More worryingly, Algonquin Power & Utilities has seen its EBIT drop 6.8% over the past twelve months. If it continues like this, paying off debt will be like running on a treadmill – a lot of effort for little progress. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the future profitability of the business will decide whether Algonquin Power & Utilities can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, Algonquin Power & Utilities has experienced substantial total negative free cash flow. While this may be the result of spending on growth, it makes debt much riskier.
Our point of view
To be frank, Algonquin Power & Utilities’ net debt to EBITDA and history of converting EBT to free cash flow makes us rather uncomfortable with its debt levels. And even his total passive level doesn’t inspire much confidence. It should also be noted that companies in the integrated utility sector like Algonquin Power & Utilities generally use debt without a problem. Overall, it seems to us that Algonquin Power & Utilities’ balance sheet is really very risky for the company. For this reason, we are quite cautious on the stock, and we believe that shareholders should closely monitor its liquidity. The balance sheet is clearly the area you need to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. Note that Algonquin Power & Utilities displays 5 warning signs in our investment analysis , and 1 of them cannot be ignored …
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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