Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Mostly, Allison Transmission Holdings, Inc. (NYSE:ALSN) is in debt. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, many companies use debt to finance their growth, without any negative consequences. When we look at debt levels, we first consider cash and debt levels, together.
Check out our latest analysis for Allison Transmission Holdings
How much debt does Allison Transmission Holdings have?
The chart below, which you can click on for more details, shows that Allison Transmission Holdings had US$2.54 billion in debt as of December 2021; about the same as the previous year. However, he has $127.0 million in cash to offset this, resulting in a net debt of approximately $2.41 billion.
How healthy is Allison Transmission Holdings’ balance sheet?
The latest balance sheet data shows that Allison Transmission Holdings had liabilities of $459.0 million due within the year, and liabilities of $3.36 billion due thereafter. In return, it had $127.0 million in cash and $301.0 million in receivables due within 12 months. Thus, its liabilities total $3.40 billion more than the combination of its cash and short-term receivables.
This shortfall is sizable relative to its market capitalization of US$3.75 billion, so it suggests shareholders should monitor Allison Transmission Holdings’ use of debt. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.
We measure a company’s leverage against its earning power 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 charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.
Allison Transmission Holdings’ debt is 2.9 times its EBITDA, and its EBIT covers its interest expense 5.8 times. This suggests that while debt levels are significant, we will refrain from labeling them as problematic. We note that Allison Transmission Holdings has grown its EBIT by 21% over the past year, which should make it easier to pay down debt in the future. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Allison Transmission Holdings can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Allison Transmission Holdings has recorded free cash flow of 74% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
Allison Transmission Holdings’ conversion of EBIT to free cash flow was a real benefit in this analysis, as was its EBIT growth rate. That said, its level of total liabilities makes us somewhat aware of potential future risks to the balance sheet. Given this range of data points, we believe Allison Transmission Holdings is in a good position to manage its level of leverage. But be warned: we believe debt levels are high enough to warrant continued monitoring. 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 outside of the balance sheet. Be aware that Allison Transmission Holdings displays 1 warning sign in our investment analysis you should know…
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.