David Iben put it well when he said: “Volatility is not a risk we care about. What matters to us is to avoid the permanent loss of capital. ‘ So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. Above all, Alliance Data Systems Company (NYSE: ADS) is in debt. But the most important question is: what risk does this debt create?
When is debt dangerous?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
See our latest analysis for Alliance Data Systems
What is Alliance Data Systems’ debt?
The image below, which you can click for more details, shows Alliance Data Systems owed US $ 17.0 billion in debt at the end of June 2021, a reduction from US $ 19.4 billion. US dollars over one year. However, it has $ 3.00 billion in cash offsetting that, leading to net debt of around $ 14.0 billion.
How strong is Alliance Data Systems’ balance sheet?
According to the latest published balance sheet, Alliance Data Systems had liabilities of US $ 10.6 billion due within 12 months and liabilities of US $ 9.19 billion due beyond 12 months. In return, he had $ 3.00 billion in cash and $ 369.0 million in receivables due within 12 months. Its liabilities therefore total $ 16.4 billion more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the $ 5.12 billion company like a towering colossus of mere mortals. We therefore believe that shareholders should watch it closely. Ultimately, Alliance Data Systems would likely need a major recapitalization if its creditors demanded repayment.
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). Thus, we consider debt versus earnings with and without amortization charges.
Strangely, Alliance Data Systems has a very high EBITDA ratio of 10.4, which implies high debt, but high interest coverage of 10.7. So either he has access to very cheap long-term debt or his interest charges will go up! It should be noted that Alliance Data Systems’ EBIT has skyrocketed after the rain, gaining 71% in the past twelve months. This will make it easier to manage your debt. The balance sheet is clearly the area you need to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Alliance Data Systems 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, while the IRS may love accounting profits, lenders only accept hard cash. We therefore always check how much of this EBIT is converted into free cash flow. Fortunately for all shareholders, Alliance Data Systems has actually generated more free cash flow than EBIT over the past three years. There is nothing better than cash flow to stay in the good graces of your lenders.
Our point of view
We feel some trepidation about the level of difficulty of Alliance Data Systems’ total liabilities, but we also have some bright spots to focus on. For example, its conversion from EBIT to free cash flow and the growth rate of EBIT give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it seems to us that Alliance Data Systems is a somewhat risky investment because of its debt. Not all risks are bad, as they can increase stock price returns if they are profitable, but this risk of leverage is worth keeping in mind. 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. Concrete example: we have spotted 3 warning signs for Alliance Data Systems you need to be aware, and 2 of them are important.
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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 any of the stocks mentioned.
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