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We Think Alcoa (NYSE:AA) Can Stay On Top Of Its Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Alcoa Corporation (NYSE:AA) does have debt on its balance sheet. But should shareholders be worried about its use of debt? When Is Debt A Problem? Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together. How Much Debt Does Alcoa Carry? The image below, which you can click on for greater detail, shows that Alcoa had debt of US$1.73b at the end of June 2022, a reduction from US$2.22b over a year. However, because it has a cash reserve of US$1.64b, its net debt is less, at about US$88.0m. A Look At Alcoa's Liabilities According to the last reported balance sheet, Alcoa had liabilities of US$3.24b due within 12 months, and liabilities of US$5.18b due beyond 12 months. Offsetting this, it had US$1.64b in cash and US$1.02b in receivables that were due within 12 months. So its liabilities total US$5.76b more than the combination of its cash and short-term receivables. This is a mountain of leverage relative to its market capitalization of US$9.49b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. But either way, Alcoa has virtually no net debt, so it's fair to say it does not have a heavy debt load! 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses. Alcoa has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.025 and EBIT of 20.6 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. Even more impressive was the fact that Alcoa grew its EBIT by 171% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Alcoa's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting. But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Alcoa recorded free cash flow of 27% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness. Our View The good news is that Alcoa's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Alcoa can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with Alcoa (including 1 which makes us a bit uncomfortable) . Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today. Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com. 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. The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc. The board of Stanley Black & Decker, Inc. (NYSE:SWK) has announced that it will be paying its dividend of $0.80 on the 20th of September, an increased payment from last year's comparable dividend. This will take the dividend yield to an attractive 3.3%, providing a nice boost to shareholder returns. Stanley Black & Decker's Payment Has Solid Earnings Coverage If the payments aren't sustainable, a high yield for a few years won't matter that much. Before making this announcement, Stanley Black & Decker was earning enough to cover the dividend, but it wasn't generating any free cash flows. In general, we consider cash flow to be more important than earnings, so we would be cautious about relying on the sustainability of this dividend. Over the next year, EPS is forecast to expand by 94.9%. If the dividend continues on this path, the payout ratio could be 27% by next year, which we think can be pretty sustainable going forward. Stanley Black & Decker Has A Solid Track Record The company has a sustained record of paying dividends with very little fluctuation. Since 2012, the annual payment back then was $1.64, compared to the most recent full-year payment of $3.20. This works out to be a compound annual growth rate (CAGR) of approximately 6.9% a year over that time. Companies like this can be very valuable over the long term, if the decent rate of growth can be maintained. The Dividend's Growth Prospects Are Limited Investors who have held shares in the company for the past few years will be happy with the dividend income they have received. Let's not jump to conclusions as things might not be as good as they appear on the surface. Stanley Black & Decker has seen earnings per share falling at 4.3% per year over the last five years. If earnings continue declining, the company may have to make the difficult choice of reducing the dividend or even stopping it completely - the opposite of dividend growth. However, the next year is actually looking up, with earnings set to rise. We would just wait until it becomes a pattern before getting too excited. In Summary Overall, this is probably not a great income stock, even though the dividend is being raised at the moment. While Stanley Black & Decker is earning enough to cover the payments, the cash flows are lacking. We would probably look elsewhere for an income investment. Companies possessing a stable dividend policy will likely enjoy greater investor interest than those suffering from a more inconsistent approach. Still, investors need to consider a host of other factors, apart from dividend payments, when analysing a company. Case in point: We've spotted 4 warning signs for Stanley Black & Decker (of which 1 is potentially serious!) you should know about. Is Stanley Black & Decker not quite the opportunity you were looking for? Why not check out our selection of top dividend stocks. Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com. 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. The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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