David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 AAR Corp. (NYSE:AIR) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is AAR's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of May 2024 AAR had US$985.4m of debt, an increase on US$269.7m, over one year. However, because it has a cash reserve of US$85.8m, its net debt is less, at about US$899.6m.

How Healthy Is AAR's Balance Sheet?

We can see from the most recent balance sheet that AAR had liabilities of US$466.9m falling due within a year, and liabilities of US$1.11b due beyond that. Offsetting this, it had US$85.8m in cash and US$423.6m in receivables that were due within 12 months. So it has liabilities totalling US$1.07b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since AAR has a market capitalization of US$2.27b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

AAR's debt is 4.4 times its EBITDA, and its EBIT cover its interest expense 4.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On a slightly more positive note, AAR grew its EBIT at 18% over the last year, further increasing its ability to manage debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine AAR'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, AAR reported free cash flow worth 16% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Both AAR's net debt to EBITDA and its conversion of EBIT to free cash flow were discouraging. At least its EBIT growth rate gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that AAR is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 4 warning signs we've spotted with AAR (including 1 which is potentially serious) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.