Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We note that Acciona, S.A. (BME:ANA) has debt on its balance sheet. But the more important question is: what risk does this debt create?
When is debt dangerous?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
See our latest analysis for Acciona
What is Acciona’s net debt?
As you can see below, Acciona had 6.38 billion euros in debt in December 2021, compared to 6.93 billion euros the previous year. On the other hand, it has €2.53 billion in cash, which results in a net debt of around €3.85 billion.
How strong is Acciona’s balance sheet?
The latest balance sheet data shows Acciona had liabilities of 6.91 billion euros due within a year, and liabilities of 7.13 billion euros falling due thereafter. On the other hand, it had 2.53 billion euros in cash and 2.82 billion euros in receivables at less than one year. It therefore has liabilities totaling 8.70 billion euros more than its cash and short-term receivables, combined.
This deficit is considerable compared to its very large market capitalization of 10.2 billion euros, so it suggests that shareholders monitor Acciona’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Acciona’s debt is 3.3 times its EBITDA, and its EBIT covers its interest expense 2.9 times. Taken together, this implies that, while we wouldn’t like to see debt levels increase, we think he can manage his current leverage. On the bright side, Acciona has increased its EBIT by 84% over the past year. Like the milk of human kindness, this type of growth increases resilience, making the business more capable of managing debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Acciona can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Acciona has burned a lot of cash. While this may be the result of spending for growth, it makes debt much riskier.
Our point of view
Reflecting on Acciona’s attempt to convert EBIT to free cash flow, we are certainly not enthusiastic. But at least it’s decent enough to increase its EBIT; it’s encouraging. It should also be noted that Acciona is part of the electric utility sector, which is often considered quite defensive. Looking at the balance sheet and taking all of these factors into account, we think the debt makes Acciona stock a bit risky. This isn’t necessarily a bad thing, but we would generally feel more comfortable with less leverage. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. For example, Acciona has 3 warning signs (and 1 which is a little obnoxious) that we think you should know about.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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