The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. We note that AMERCO (NASDAQ:UHAL) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.

What Is AMERCO’s Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 AMERCO had US$4.12b of debt, an increase on US$3.75b, over one year. However, it does have US$1.40b in cash offsetting this, leading to net debt of about US$2.72b.

How Strong Is AMERCO’s Balance Sheet?

We can see from the most recent balance sheet that AMERCO had liabilities of US$1.34b falling due within a year, and liabilities of US$8.35b due beyond that. Offsetting this, it had US$1.40b in cash and US$259.4m in receivables that were due within 12 months. So it has liabilities totalling US$8.03b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of US$12.1b, so it does suggest shareholders should keep an eye on AMERCO’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

AMERCO has net debt worth 1.9 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 5.1 times the interest expense. While that doesn’t worry us too much, it does suggest the interest payments are somewhat of a burden. It is well worth noting that AMERCO’s EBIT shot up like bamboo after rain, gaining 48% in the last twelve months. That’ll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine AMERCO’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the last three years, AMERCO saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

AMERCO’s conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think AMERCO’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. 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.