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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that AerCap Holdings N.V. (NYSE:AER) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company’s use of debt, we first look at cash and debt together.

How Much Debt Does AerCap Holdings Carry?

The image below, which you can click on for greater detail, shows that at June 2022 AerCap Holdings had debt of US$47.9b, up from US$28.2b in one year. However, it does have US$1.33b in cash offsetting this, leading to net debt of about US$46.6b.

How Strong Is AerCap Holdings’ Balance Sheet?

Zooming in on the latest balance sheet data, we can see that AerCap Holdings had liabilities of US$3.44b due within 12 months and liabilities of US$51.2b due beyond that. On the other hand, it had cash of US$1.33b and US$4.05b worth of receivables due within a year. So it has liabilities totalling US$49.3b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the US$12.8b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, AerCap Holdings 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.9 times and a disturbingly high net debt to EBITDA ratio of 17.1 hit our confidence in AerCap Holdings like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. On the other hand, AerCap Holdings grew its EBIT by 29% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine AerCap Holdings’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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, AerCap Holdings recorded free cash flow of 34% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.

Our View

On the face of it, AerCap Holdings’s net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at growing its EBIT; that’s encouraging. We’re quite clear that we consider AerCap Holdings to be really rather risky, as a result of its balance sheet health. 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.