Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Armour Energy Limited (ASX:AJQ) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Armour Energy Carry?
The image below, which you can click on for greater detail, shows that at December 2018 Armour Energy had debt of AU$44.6m, up from AU$32.6m in one year. However, it does have AU$7.68m in cash offsetting this, leading to net debt of about AU$36.9m.
A Look At Armour Energy's Liabilities
The latest balance sheet data shows that Armour Energy had liabilities of AU$53.2m due within a year, and liabilities of AU$11.8m falling due after that. Offsetting this, it had AU$7.68m in cash and AU$5.78m in receivables that were due within 12 months. So it has liabilities totalling AU$51.5m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the AU$33.1m 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 At the end of the day, Armour Energy would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Armour Energy shareholders face the double whammy of a high net debt to EBITDA ratio (16.7), and fairly weak interest coverage, since EBIT is just 0.11 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Armour Energy is that it turned last year's EBIT loss into a gain of AU$1.0m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Armour Energy's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Armour Energy saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Armour Energy's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. After considering the datapoints discussed, we think Armour Energy has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given the risks around Armour Energy's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.