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. Importantly, Aker BP ASA (OB:AKERBP) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Aker BP's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Aker BP had US$2.66b of debt in June 2019, down from US$3.03b, one year before. On the flip side, it has US$101.8m in cash leading to net debt of about US$2.56b.
How Strong Is Aker BP's Balance Sheet?
We can see from the most recent balance sheet that Aker BP had liabilities of US$1.39b falling due within a year, and liabilities of US$7.44b due beyond that. Offsetting these obligations, it had cash of US$101.8m as well as receivables valued at US$336.9m due within 12 months. So it has liabilities totalling US$8.39b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$9.88b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Aker BP has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 26.0 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Aker BP grew its EBIT by 6.9% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Aker BP 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 always check how much of that EBIT is translated into free cash flow. Over the last three years, Aker BP recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Aker BP's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. All these things considered, it appears that Aker BP can comfortably handle its current debt levels. 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. We'd be motivated to research the stock further if we found out that Aker BP insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
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