Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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 note that Alcoa Corporation (NYSE:AA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Alcoa Carry?
The image below, which you can click on for greater detail, shows that Alcoa had debt of US$1.73b at the end of June 2022, a reduction from US$2.22b over a year. However, because it has a cash reserve of US$1.64b, its net debt is less, at about US$88.0m.
A Look At Alcoa’s Liabilities
According to the last reported balance sheet, Alcoa had liabilities of US$3.24b due within 12 months, and liabilities of US$5.18b due beyond 12 months. Offsetting this, it had US$1.64b in cash and US$1.02b in receivables that were due within 12 months. So its liabilities total US$5.76b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$9.49b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. But either way, Alcoa has virtually no net debt, so it’s fair to say it does not have a heavy debt load!
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Alcoa has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.025 and EBIT of 20.6 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. Even more impressive was the fact that Alcoa grew its EBIT by 171% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Alcoa’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, Alcoa recorded free cash flow of 27% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
The good news is that Alcoa’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Alcoa can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. There’s no doubt that we learn most about debt from the balance sheet.