Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to 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 Avista Corporation (NYSE:AVA) has debt on its balance sheet. But does this debt worry shareholders?
Why is debt risky?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. 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 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.
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What is Avista’s debt?
You can click on the graph below for historical numbers, but it shows that in March 2022 Avista had debt of $2.61 billion, an increase from $2.28 billion, year-over-year . However, he also had $203.6 million in cash, so his net debt is $2.41 billion.
How strong is Avista’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Avista had liabilities of US$641.9 million due within 12 months and liabilities of US$4.16 billion due beyond. On the other hand, it had liquidities of 203.6 million dollars and 227.6 million dollars of accounts receivable within one year. It therefore has liabilities totaling $4.37 billion more than its cash and short-term receivables, combined.
When you consider that shortfall exceeds the company’s US$3.09 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.
Avista shareholders face the double whammy of a high net debt to EBITDA ratio (5.4) and quite low interest coverage, as EBIT is only 2.1 times expenses of interests. The debt burden here is considerable. Another concern for investors could be that Avista’s EBIT fell 15% last year. If this is how things continue, managing the debt burden will be like delivering hot coffees on a pogo stick. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Avista’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 business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Avista has burned a lot of cash. While investors no doubt expect a reversal of this situation in due course, it clearly means that its use of debt is more risky.
Our point of view
At first glance, Avista’s level of total liabilities left us wondering about the stock, and its EBIT to free cash flow conversion was no more appealing than the single empty restaurant on the busiest night in the world. year. Moreover, its interest coverage also fails to inspire confidence. It should also be noted that Avista belongs to the integrated utilities sector, which is often considered quite defensive. We think the chances of Avista having too much debt are very high. For us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel otherwise. 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, we have identified 4 warning signs for Avista (1 should not be ignored) which you should be aware of.
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.