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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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Braemar Shipping Services plc (LON:BMS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Braemar Shipping Services's Debt?
As you can see below, at the end of August 2019, Braemar Shipping Services had UK£39.1m of debt, up from UK£28.7m a year ago. Click the image for more detail. On the flip side, it has UK£4.81m in cash leading to net debt of about UK£34.3m.
How Healthy Is Braemar Shipping Services's Balance Sheet?
The latest balance sheet data shows that Braemar Shipping Services had liabilities of UK£83.7m due within a year, and liabilities of UK£26.9m falling due after that. Offsetting this, it had UK£4.81m in cash and UK£42.3m in receivables that were due within 12 months. So it has liabilities totalling UK£63.5m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's UK£59.7m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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.
Braemar Shipping Services has a debt to EBITDA ratio of 3.6 and its EBIT covered its interest expense 6.2 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Braemar Shipping Services grew its EBIT by 5.5% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Braemar Shipping Services can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Braemar Shipping Services's free cash flow amounted to 47% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Both Braemar Shipping Services's level of total liabilities and its net debt to EBITDA were discouraging. But its not so bad at growing its EBIT. We should also note that Infrastructure industry companies like Braemar Shipping Services commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Braemar Shipping Services is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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