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. Importantly, AAR Corp. (NYSE:AIR) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is AAR’s Debt?
The image below, which you can click on for greater detail, shows that AAR had debt of US$103.2m at the end of November 2021, a reduction from US$220.3m over a year. On the flip side, it has US$42.7m in cash leading to net debt of about US$60.5m.
A Look At AAR’s Liabilities
According to the last reported balance sheet, AAR had liabilities of US$320.2m due within 12 months, and liabilities of US$202.4m due beyond 12 months. On the other hand, it had cash of US$42.7m and US$260.6m worth of receivables due within a year. So its liabilities total US$219.3m more than the combination of its cash and short-term receivables.
Since publicly traded AAR shares are worth a total of US$1.47b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
AAR’s net debt is only 0.65 times its EBITDA. And its EBIT easily covers its interest expense, being 18.9 times the size. So we’re pretty relaxed about its super-conservative use of debt. In addition to that, we’re happy to report that AAR has boosted its EBIT by 51%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine AAR’s ability to maintain a healthy balance sheet going forward.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, AAR produced sturdy free cash flow equating to 69% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Happily, AAR’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. Overall, we don’t think AAR is taking any bad risks, as its debt load seems modest. So we’re not worried about the use of a little leverage on the balance sheet.