Is Ashtead Group (LON: AHT) a risky investment?

Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital.” 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, Ashtead group plc (LON: AHT) is in debt. But should shareholders be concerned about its use of debt?

Why Does Debt Bring Risk?

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. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. The first step in examining a business’s debt levels is to consider its cash flow and debt together.

Check out our latest analysis for Ashtead Group

What is Ashtead Group’s debt?

The graph below, which you can click for more details, shows that Ashtead Group had debt of US $ 4.68 billion as of October 2021; about the same as the year before. And he doesn’t have a lot of cash, so his net debt is about the same.

LSE: AHT Debt to equity history December 28, 2021

How healthy is Ashtead Group’s balance sheet?

According to the latest published balance sheet, Ashtead Group had liabilities of US $ 1.34 billion due within 12 months and liabilities of US $ 7.98 billion due beyond 12 months. On the other hand, it had US $ 15.4 million in cash and US $ 1.46 billion in receivables due within one year. Its liabilities therefore total $ 7.85 billion more than the combination of its cash and short-term receivables.

While that might sound like a lot, it’s not that bad as Ashtead Group has a massive market cap of $ 35.9 billion, so it could likely strengthen its balance sheet by raising capital if it had to. But we absolutely want to keep our eyes open for indications that its debt is too risky.

We measure a company’s indebtedness relative to its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating the ease with which its earnings before interest and taxes (EBIT ) covers its interests. costs (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

Looking at its net debt over EBITDA of 1.4 and interest coverage of 6.1 times, it seems to us that Ashtead Group is probably using the debt in a fairly reasonable way. We therefore recommend that you keep a close eye on the impact of financing costs on the business. On top of that, Ashtead Group has increased its EBIT by 31% over the past twelve months, and this growth will make it easier to process its 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 Ashtead Group can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.

Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, Ashtead Group has generated strong free cash flow equivalent to 76% of its EBIT, roughly what we expected. This hard cash allows him to reduce his debt whenever he wants.

Our point of view

Ashtead Group’s EBIT growth rate suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. And this is only the beginning of good news as its conversion from EBIT to free cash flow is also very encouraging. When zoomed out, Ashtead Group appears to be using debt quite sensibly; and that gets the nod from us. While debt comes with risk, when used wisely, it can also generate a better return on equity. When analyzing debt levels, the balance sheet is the obvious place to start. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 1 warning sign for Ashtead Group which you should know before investing here.

If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash-flow net-growth stocks.

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 any stock 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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