Warren Buffett said: “Volatility is far from synonymous with risk. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We can see that ALLETE, Inc. (NYSE: ALE) uses debt in its operations. 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. If things go really bad, lenders can take over the business. 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 thing to do when considering how much debt a business has is to look at its cash and debt together.
What is ALLETE’s net debt?
The graph below, which you can click on for more details, shows that ALLETE had $1.99 billion in debt as of June 2022; about the same as the previous year. However, since he has a cash reserve of $74.6 million, his net debt is less, at around $1.91 billion.
How strong is ALLETE’s balance sheet?
The latest balance sheet data shows that ALLETE had liabilities of $709.0 million due within the year, and liabilities of $2.77 billion due thereafter. On the other hand, it had liquidities of 74.6 million dollars and 116.2 million dollars of receivables at less than one year. Thus, its liabilities total $3.29 billion more than the combination of its cash and short-term receivables.
This shortfall is sizable relative to its market capitalization of US$3.42 billion, so it suggests shareholders should monitor ALLETE’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its 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 ).
While ALLETE’s debt to EBITDA ratio (4.9) suggests that it uses some debt, its interest coverage is very low at 2.2, suggesting high leverage. This is largely due to the company’s large amortization charges, which no doubt means that its EBITDA is a very generous measure of earnings, and that its debt may be heavier than it first appears. on board. Shareholders should therefore probably be aware that interest charges seem to have had a real impact on the company lately. Given the leverage, it’s hardly ideal that ALLETE’s EBIT has been fairly flat over the past twelve months. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine ALLETE’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a company can only repay its debts with cold hard cash, not with book profits. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, ALLETE has experienced significant negative free cash flow, in total. While this may be the result of spending for growth, it makes debt much riskier.
Our point of view
At first glance, ALLETE’s interest coverage left us hesitant about the stock, and its EBIT-to-free-cash-flow conversion was no more appealing than the single empty restaurant on the busiest night of the year. year. But at least its EBIT growth rate isn’t that bad. It should also be noted that ALLETE is in the electric utility industry, which is often seen as quite defensive. We are very clear that we consider ALLETE to be really quite risky, given the health of its balance sheet. For this reason, we are quite cautious about the stock and believe shareholders should keep a close eye on its liquidity. 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. These risks can be difficult to spot. Every business has them, and we’ve spotted 3 warning signs for ALLETE (1 of which is a little unpleasant!) that you should know about.
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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