Alliance Data Systems (NYSE:ADS) has a somewhat stretched balance sheet

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”. 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. Above all, Alliance Data Systems Corporation (NYSE:ADS) is in debt. But does this debt worry shareholders?

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. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we think about a company’s use of debt, we first look at cash and debt together.

Check out our latest analysis for Alliance Data Systems

What is Alliance Data Systems’ net debt?

As you can see below, Alliance Data Systems had $18.5 billion in debt as of December 2021, roughly the same as the year before. You can click on the graph for more details. On the other hand, it has $3.05 billion in cash, resulting in a net debt of around $15.4 billion.

NYSE: Historical Debt to Equity ADS February 5, 2022

How healthy is Alliance Data Systems’ balance sheet?

According to the last published balance sheet, Alliance Data Systems had liabilities of US$4.00 million due within 12 months and liabilities of US$19.7 billion due beyond 12 months. In return, he had $3.05 billion in cash and $371.5 million in receivables due within 12 months. It therefore has liabilities totaling $16.2 billion more than its cash and short-term receivables, combined.

This deficit casts a shadow over the $3.45 billion company, like a colossus towering above mere mortals. We would therefore be watching his balance sheet closely, no doubt. Ultimately, Alliance Data Systems would likely need a major recapitalization if its creditors were to demand repayment.

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.

Alliance Data Systems’ net debt to EBITDA ratio is 13.2, suggesting rather high debt levels, but its interest coverage of 8.9 times suggests debt is easily repaid. Overall, we’d say it seems likely that the company is carrying quite a heavy debt load. It should be noted that Alliance Data Systems’ EBIT has surged like bamboo after rain, gaining 92% over the last twelve months. This will make it easier to manage your debt. 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 Alliance Data Systems’ ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

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. Fortunately for all shareholders, Alliance Data Systems has actually produced more free cash flow than EBIT for the past three years. There’s nothing better than incoming money to stay in the good books of your lenders.

Our point of view

We feel some trepidation about the difficulty level of Alliance Data Systems’ total passive, but we also have some positives to focus on. The EBIT to free cash flow conversion and the EBIT growth rate were encouraging signs. We think Alliance Data Systems’ debt makes it a bit risky, after looking at the aforementioned data points together. This isn’t necessarily a bad thing, since leverage can increase return on equity, but it is something to be aware of. 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. For example, we found 3 warning signs for Alliance Data Systems (2 are a little nasty!) that you should be aware of before investing here.

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.

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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