David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Arcos Dorados Holdings Inc. (NYSE:ARCO) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Arcos Dorados Holdings Carry?
As you can see below, at the end of March 2021, Arcos Dorados Holdings had US$788.7m of debt, up from US$757.4m a year ago. Click the image for more detail. However, it does have US$148.3m in cash offsetting this, leading to net debt of about US$640.4m.
How Strong Is Arcos Dorados Holdings’ Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Arcos Dorados Holdings had liabilities of US$447.4m due within 12 months and liabilities of US$1.56b due beyond that. Offsetting this, it had US$148.3m in cash and US$92.5m in receivables that were due within 12 months. So its liabilities total US$1.77b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company’s US$1.38b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Arcos Dorados Holdings’s ability to maintain a healthy balance sheet going forward.
Over 12 months, Arcos Dorados Holdings made a loss at the EBIT level, and saw its revenue drop to US$1.9b, which is a fall of 32%. To be frank that doesn’t bode well.
While Arcos Dorados Holdings’s falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost US$59m at the EBIT level. When we look at that alongside the significant liabilities, we’re not particularly confident about the company. We’d want to see some strong near-term improvements before getting too interested in the stock. It’s fair to say the loss of US$127m didn’t encourage us either; we’d like to see a profit. And until that time we think this is a risky stock. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it.