Here’s Why Aurizon Holdings (ASX: AZJ) Can Responsibly Manage Debt
Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Above all, Aurizon Holdings Limited (ASX: AZJ) carries a debt. But the real question is whether this debt makes the business risky.
When Is Debt a Problem?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
Check out our latest analysis for Aurizon Holdings
What is Aurizon Holdings’ net debt?
As you can see below, Aurizon Holdings was in debt of A $ 3.80 billion in June 2021, which is roughly the same as the year before. You can click on the graph for more details. On the other hand, it has A $ 148.8 million in cash, resulting in net debt of around A $ 3.66 billion.
How healthy is Aurizon Holdings’ balance sheet?
We can see from the most recent balance sheet that Aurizon Holdings had A $ 717.2 million liabilities due within one year and A $ 4.77 billion liabilities beyond. In return, he had A $ 148.8 million in cash and A $ 501.6 million in receivables due within 12 months. Its liabilities therefore total AU $ 4.84 billion more than the combination of its cash and short-term receivables.
This is a mountain of leverage compared to its market cap of A $ 6.79 billion. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.
We measure a company’s debt load relative to its earning capacity 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 costs (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Aurizon Holdings’ net debt stands at a very reasonable level of 2.5 times its EBITDA, while its EBIT only covered its interest expense 6.1 times last year. While this doesn’t worry us too much, it does suggest that the interest payments are somewhat of a burden. It is important to note that Aurizon Holdings’ EBIT has remained essentially stable over the past twelve months. We would rather see some growth in earnings as it always helps reduce debt. 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 Aurizon Holdings can strengthen its balance sheet over time. 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 repay its debts; accounting profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Aurizon Holdings has recorded free cash flow totaling 84% of its EBIT, which is higher than what we usually expected. This puts him in a very strong position to pay off the debt.
Our point of view
When it comes to the balance sheet, the bright spot for Aurizon Holdings was that it appears to be able to convert EBIT to free cash flow with confidence. However, our other observations were not so encouraging. For example, his total liability level makes us a little nervous about his debt. When we consider all of the factors mentioned above, we feel a little cautious about Aurizon Holdings’ use of debt. While we understand that debt can improve returns on equity, we suggest shareholders watch their debt level closely, lest they increase. 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 off the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 3 warning signs for Aurizon Holdings (1 of which should not be ignored!) that you should know.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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