Warren Buffett said: “Volatility is far from synonymous with risk. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We can see that ACEA SpA (BIT:ACE) uses debt in its business. But should shareholders worry about its use of debt?
What risk does debt carry?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we think about a company’s use of debt, we first look at cash and debt together.
Discover our latest analysis for ACEA
What is ACEA’s debt?
You can click on the graph below for historical figures, but it shows that in December 2021 ACEA had €5.02 billion in debt, an increase from €4.50 billion, over a year. However, he also had €683.1 million in cash, so his net debt is €4.34 billion.
A look at ACEA’s responsibilities
According to the latest published balance sheet, ACEA had liabilities of €2.60 billion maturing within 12 months and liabilities of €5.51 billion maturing beyond 12 months. On the other hand, it had cash of €683.1 million and €1.80 billion in receivables at less than one year. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by €5.63 billion.
This deficit casts a shadow over the 3.48 billion euro company, like a colossus towering above mere mortals. We would therefore be watching his balance sheet closely, no doubt. Ultimately, ACEA would likely need a major recapitalization if its creditors were to demand repayment.
We measure a company’s leverage against its earning power 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 charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
With a net debt to EBITDA ratio of 4.2 ACEA has quite a significant amount of debt. But the high interest coverage of 7.3 suggests it can easily repay that debt. One way for ACEA to overcome its debt would be to stop borrowing more but continue to grow EBIT by around 19%, as it did last year. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether ACEA can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, ACEA has experienced substantial negative free cash flow, in total. While this may be the result of spending for growth, it makes debt much riskier.
Our point of view
At first glance, ACEA’s conversion of EBIT to free cash flow left us hesitant about the stock, and its level of total liabilities was no more appealing than the single empty restaurant on the busiest night of the year. But at least it’s decent enough to increase its EBIT; it’s encouraging. It should also be noted that companies in the integrated utility sector like ACEA generally use debt without a problem. Overall, it seems to us that ACEA’s balance sheet is really a risk for the company. We are therefore almost as wary of this stock as a hungry kitten of falling into its owner’s fish pond: once bitten, twice shy, as they say. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. Example: we have identified 2 warning signs for ACEA you need to be aware of, and 1 of them should not be ignored.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
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.