David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Arcos Dorados Holdings Inc. (NYSE:ARCO) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Arcos Dorados Holdings Carry?
The chart below, which you can click on for greater detail, shows that Arcos Dorados Holdings had US$765.7m in debt in June 2024; about the same as the year before. On the flip side, it has US$139.4m in cash leading to net debt of about US$626.4m.
How Strong Is Arcos Dorados Holdings' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Arcos Dorados Holdings had liabilities of US$816.6m due within 12 months and liabilities of US$1.61b due beyond that. On the other hand, it had cash of US$139.4m and US$180.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.11b.
When you consider that this deficiency exceeds the company's US$1.98b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With net debt sitting at just 1.3 times EBITDA, Arcos Dorados Holdings is arguably pretty conservatively geared. And it boasts interest cover of 10.0 times, which is more than adequate. Fortunately, Arcos Dorados Holdings grew its EBIT by 6.4% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Arcos Dorados Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Arcos Dorados Holdings's free cash flow amounted to 26% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Our View
Arcos Dorados Holdings's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Arcos Dorados Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Arcos Dorados Holdings has 2 warning signs we think you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
