Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that AusNet Services Ltd (ASX:AST) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company 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 and debt together.
Check out our latest analysis for AusNet Services
What Is AusNet Services's Net Debt?
The image below, which you can click on for greater detail, shows that at March 2019 AusNet Services had debt of AU$8.30b, up from AU$7.83b in one year. On the flip side, it has AU$345.0m in cash leading to net debt of about AU$7.95b.
A Look At AusNet Services's Liabilities
We can see from the most recent balance sheet that AusNet Services had liabilities of AU$1.40b falling due within a year, and liabilities of AU$8.12b due beyond that. On the other hand, it had cash of AU$345.0m and AU$212.0m worth of receivables due within a year. So it has liabilities totalling AU$8.97b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's AU$6.56b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.