Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies The AES Corporation (NYSE:AES) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does AES Carry?
You can click the graphic below for the historical numbers, but it shows that AES had US$19.5b of debt in March 2021, down from US$21.1b, one year before. On the flip side, it has US$2.07b in cash leading to net debt of about US$17.4b.
How Healthy Is AES’ Balance Sheet?
We can see from the most recent balance sheet that AES had liabilities of US$5.02b falling due within a year, and liabilities of US$24.5b due beyond that. Offsetting this, it had US$2.07b in cash and US$1.34b in receivables that were due within 12 months. So it has liabilities totalling US$26.1b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$16.6b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, AES would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
AES has a debt to EBITDA ratio of 4.9 and its EBIT covered its interest expense 3.4 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. On the other hand, AES grew its EBIT by 20% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine AES’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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, AES reported free cash flow worth 13% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Our View
Mulling over AES’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Overall, it seems to us that AES’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet.