Is Allison Transmission Holdings (NYSE:ALSN) a risky investment?
Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Above all, Allison Transmission Holdings, Inc. (NYSE:ALSN) is in debt. But should shareholders worry about its use of debt?
What risk does debt carry?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
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$2.55 billion in debt as of September 2021; about the same as the previous year. However, he has $261.0 million in cash to offset this, resulting in a net debt of approximately $2.29 billion.
A look at the liabilities of Allison Transmission Holdings
According to the last published balance sheet, Allison Transmission Holdings had liabilities of US$448.0 million due within 12 months and liabilities of US$3.38 billion due beyond 12 months. In compensation for these obligations, it had cash of US$261.0 million as well as receivables valued at US$257.0 million and maturing within 12 months. It therefore has liabilities totaling $3.31 billion more than its cash and short-term receivables, combined.
This is a mountain of leverage compared to its market capitalization of US$4.29 billion. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
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). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Allison Transmission Holdings has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 5.2 times. This suggests that while debt levels are significant, we will refrain from labeling them as problematic. Allison Transmission Holdings increased its EBIT by 7.9% over the past year. While that barely brings us down, it’s a positive when it comes to 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 Allison Transmission Holdings 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.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Allison Transmission Holdings has produced strong free cash flow equivalent to 76% of its EBIT, which is what we expected. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
According to our analysis, the conversion of EBIT to free cash flow by Allison Transmission Holdings should indicate that it will not have too many problems with its debt. But the other factors we noted above weren’t so encouraging. For example, it looks like he has to struggle a bit to manage his total liabilities. When we consider all the factors mentioned above, we feel a bit cautious about Allison Transmission Holdings’ use of debt. While we understand that debt can improve returns on equity, we suggest shareholders keep a close eye on their level of debt, lest it increase. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Example: we have identified 1 warning sign for Allison Transmission Holdings you should be aware.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
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.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.