Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 ShaMaran Petroleum Corp (CVE:SNM) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is ShaMaran Petroleum's Debt?
The chart below, which you can click on for greater detail, shows that ShaMaran Petroleum had US$189.5m in debt in June 2019; about the same as the year before. However, it does have US$19.5m in cash offsetting this, leading to net debt of about US$169.9m.
How Strong Is ShaMaran Petroleum's Balance Sheet?
The latest balance sheet data shows that ShaMaran Petroleum had liabilities of US$17.5m due within a year, and liabilities of US$205.7m falling due after that. On the other hand, it had cash of US$19.5m and US$46.4m worth of receivables due within a year. So it has liabilities totalling US$157.3m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of US$122.0m, we think shareholders really should watch ShaMaran Petroleum's debt levels, like a parent watching their child ride a bike for the first time. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
ShaMaran Petroleum shareholders face the double whammy of a high net debt to EBITDA ratio (6.0), 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. Worse, ShaMaran Petroleum's EBIT was down 87% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 ShaMaran Petroleum 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, ShaMaran Petroleum recorded free cash flow worth a fulsome 99% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
On the face of it, ShaMaran Petroleum's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider ShaMaran Petroleum to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Given our concerns about ShaMaran Petroleum's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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