We think Alcoa (NYSE:AA) can stay on top of its debt

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Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We note that Alcoa Company (NYSE:AA) has debt on its balance sheet. But should shareholders worry about its use of debt?

When is debt a problem?

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. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we think about a company’s use of debt, we first look at cash and debt together.

What is Alcoa’s debt?

The image below, which you can click on for more details, shows Alcoa had $1.73 billion in debt at the end of June 2022, down from $2.22 billion year-over-year. However, since it has a cash reserve of $1.64 billion, its net debt is less, at around $88.0 million.

NYSE: AA Debt to Equity History August 14, 2022

A look at Alcoa’s responsibilities

According to the last published balance sheet, Alcoa had liabilities of US$3.24 billion due within 12 months and liabilities of US$5.18 billion due beyond 12 months. In return, he had $1.64 billion in cash and $1.02 billion in receivables due within 12 months. Thus, its liabilities total $5.76 billion more than the combination of its cash and short-term receivables.

This is a mountain of leverage compared to its market capitalization of US$9.49 billion. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly. Either way, Alcoa has virtually no net debt, so it’s fair to say it’s not heavily indebted!

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). Thus, we consider debt to earnings with and without amortization and depreciation expense.

Alcoa has very little debt (net of cash) and has a debt to EBITDA ratio of 0.025 and an EBIT of 20.6 times interest expense. Indeed, relative to its earnings, its leverage seems light as a feather. What is even more impressive is that Alcoa increased its EBIT by 171% year-over-year. If sustained, this growth will make debt even more manageable in years to come. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine Alcoa’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.

But our last consideration is also important, because a company cannot pay off its debts 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, Alcoa has recorded free cash flow of 27% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.

Our point of view

The good news is that Alcoa’s demonstrated ability to cover its interest costs with its EBIT delights us like a fluffy puppy does a toddler. But truth be told, we think his conversion of EBIT to free cash flow somewhat undermines that impression. Looking at all of the above factors together, it seems to us that Alcoa can manage its debt quite comfortably. On the plus side, this leverage can increase shareholder returns, but the potential downside is more risk of loss, so it’s worth keeping an eye on the balance sheet. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. To do this, you need to find out about the 2 warning signs we spotted with Alcoa (including 1 that makes us a little uncomfortable).

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.

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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.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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