Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that DNO ASA (OB:DNO) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 DNO's Net Debt?
As you can see below, at the end of June 2019, DNO had US$1.08b of debt, up from US$611.9m a year ago. Click the image for more detail. However, it does have US$573.8m in cash offsetting this, leading to net debt of about US$506.9m.
A Look At DNO's Liabilities
We can see from the most recent balance sheet that DNO had liabilities of US$309.2m falling due within a year, and liabilities of US$1.71b due beyond that. Offsetting these obligations, it had cash of US$573.8m as well as receivables valued at US$432.5m due within 12 months. So it has liabilities totalling US$1.02b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$1.30b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
While DNO's low debt to EBITDA ratio of 0.70 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.3 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. In fact DNO's saving grace is its low debt levels, because its EBIT has tanked 25% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 DNO 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, DNO's free cash flow amounted to 46% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Mulling over DNO's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making DNO stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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.
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