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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, East Energy Resources Limited (ASX:EER) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is East Energy Resources's Net Debt?
You can click the graphic below for the historical numbers, but it shows that East Energy Resources had AU$400.0k of debt in December 2018, down from AU$27.4m, one year before. However, it also had AU$113.8k in cash, and so its net debt is AU$286.2k.
How Strong Is East Energy Resources's Balance Sheet?
According to the last reported balance sheet, East Energy Resources had liabilities of AU$135.4k due within 12 months, and liabilities of AU$400.0k due beyond 12 months. On the other hand, it had cash of AU$113.8k and AU$83.3k worth of receivables due within a year. So it has liabilities totalling AU$338.3k more than its cash and near-term receivables, combined.
Of course, East Energy Resources has a market capitalization of AU$9.60m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since East Energy Resources will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Given its lack of meaningful operating revenue, East Energy Resources shareholders no doubt hope it can fund itself until it can sell some combustibles.
Not only did East Energy Resources's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). To be specific the EBIT loss came in at AU$587k. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled AU$595k in negative free cash flow over the last twelve months. So in short it's a really risky stock. When we look at a riskier company, we like to check how their profits (or losses) are trending over time. Today, we're providing readers this interactive graph showing how East Energy Resources's profit, revenue, and operating cashflow have changed over the last few years.
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.
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