The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies AT&T Inc. (NYSE:T) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is AT&T's Debt?
The image below, which you can click on for greater detail, shows that at June 2021 AT&T had debt of US$181.0b, up from US$168.7b in one year. However, because it has a cash reserve of US$11.9b, its net debt is less, at about US$169.0b.
How Healthy Is AT&T's Balance Sheet?
The latest balance sheet data shows that AT&T had liabilities of US$82.1b due within a year, and liabilities of US$282.7b falling due after that. Offsetting this, it had US$11.9b in cash and US$20.1b in receivables that were due within 12 months. So its liabilities total US$332.9b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$192.8b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, AT&T would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
AT&T has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 4.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Fortunately, AT&T grew its EBIT by 4.7% in the last year, slowly shrinking its debt relative to earnings. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if AT&T can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, AT&T recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Our View
We'd go so far as to say AT&T's level of total liabilities was disappointing. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that AT&T's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Case in point: We've spotted 2 warning signs for AT&T you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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.
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