Is Archrock (NYSE:AROC) using too much debt?

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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Above all, Archrock, Inc. (NYSE:AROC) is in debt. But should shareholders worry about its use of debt?

What risk does debt carry?

Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. If things go really bad, lenders can take over the business. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first step when considering a company’s debt levels is to consider its cash and debt together.

See our latest analysis for Archrock

What is Archrock’s debt?

You can click on the chart below for historical numbers, but it shows Archrock had $1.53 billion in debt in June 2022, up from $1.62 billion a year prior. And he doesn’t have a lot of cash, so his net debt is about the same.

NYSE: AROC Debt to Equity History as of September 1, 2022

How healthy is Archrock’s balance sheet?

Zooming in on the latest balance sheet data, we can see that Archrock had liabilities of US$151.5 million due within 12 months and liabilities of US$1.58 billion due beyond. On the other hand, it had liquidities of 1.95 million dollars and 129.3 million dollars of accounts receivable within one year. Thus, its liabilities outweigh the sum of its cash and (current) receivables by $1.60 billion.

When you consider that shortfall exceeds the company’s US$1.15 billion market capitalization, you might well be inclined to take a close look at the balance sheet. In the scenario where the company were to quickly clean up its balance sheet, it seems likely that shareholders would suffer significant dilution.

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). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

Archrock shareholders face the double whammy of a high net debt to EBITDA ratio (5.0) and fairly low interest coverage, as EBIT is only 1.3 times expenses of interests. This means that we would consider him to be heavily indebted. Worse still, Archrock’s EBIT was down 21% year over year. If profits continue like this in the long term, there is an unimaginable chance of repaying this debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it’s Archrock’s earnings that will influence the balance sheet going forward. So, if you want to know more about its earnings, it may be worth checking out this graph of its long-term trend.

But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Archrock has produced strong free cash flow equivalent to 60% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.

Our point of view

At first glance, Archrock’s interest coverage left us hesitant about the stock, and its EBIT growth rate was no more appealing than the single empty restaurant on the busiest night of the year. But at least it’s decent enough to convert EBIT to free cash flow; it’s encouraging. Considering all the aforementioned factors, it seems that Archrock has too much debt. While some investors like this kind of risky play, it’s definitely not our cup of tea. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, we found 4 warning signs for Archrock (2 are concerning!) that you should be aware of before investing here.

Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.

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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