AltaGas (TSE:ALA) seems to use a lot of debt

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 “. 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, AltaGas Ltd. (TSE:ALA) is in debt. But does this debt worry shareholders?

When is debt dangerous?

Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own 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 thing to do when considering how much debt a business has is to look at its cash and debt together.

Check out our latest analysis for AltaGas

What is AltaGas’ debt?

As you can see below, AltaGas had C$7.88 billion in debt as of June 2022, which is about the same as the previous year. You can click on the graph for more details. However, it also had C$229.0 million in cash, so its net debt is C$7.65 billion.

TSX: ALA Debt to Equity History October 8, 2022

A Look at AltaGas Liabilities

Zooming in on the latest balance sheet data, we can see that AltaGas had liabilities of C$3.70 billion due within 12 months and liabilities of C$10.8 billion due beyond. On the other hand, it had liquid assets of C$229.0 million and C$1.71 billion of receivables due within one year. Thus, its liabilities total C$12.5 billion more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the C$7.30 billion business itself, like a child struggling under the weight of a huge backpack full of books, his gym gear and a trumpet. So we definitely think shareholders need to watch this one closely. Ultimately, AltaGas would likely need a significant recapitalization if its creditors demanded 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). Thus, we consider debt to earnings with and without amortization and depreciation expense.

With a net debt to EBITDA ratio of 5.2, it’s fair to say that AltaGas has significant debt. However, its interest coverage of 3.7 is reasonably strong, which is a good sign. Fortunately, AltaGas has grown its EBIT by 8.0% over the past year, slowly reducing its debt relative to its earnings. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether AltaGas can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, AltaGas has had negative free cash flow, overall. Debt is generally more expensive and almost always riskier in the hands of a company with negative free cash flow. Shareholders should hope for an improvement.

Our point of view

At first glance, AltaGas’s net debt to EBITDA ratio left us wondering about the stock, and its level of total liabilities was no more appealing than the single empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign and makes us more optimistic. It’s also worth noting that companies in the gas utility industry like AltaGas routinely use debt without issue. We are very clear that we consider AltaGas to be 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. The balance sheet is clearly the area to focus on when analyzing debt. 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 AltaGas (of which 1 is worrying!) that you should know about.

If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-flowing growth stocks without further ado.

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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