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.' 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. We note that Ranger Energy Services, Inc. (NYSE:RNGR) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Ranger Energy Services Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Ranger Energy Services had US$63.6m of debt, an increase on US$49.8m, over one year. However, because it has a cash reserve of US$1.70m, its net debt is less, at about US$61.9m.
A Look At Ranger Energy Services's Liabilities
According to the last reported balance sheet, Ranger Energy Services had liabilities of US$57.9m due within 12 months, and liabilities of US$57.9m due beyond 12 months. Offsetting this, it had US$1.70m in cash and US$60.0m in receivables that were due within 12 months. So its liabilities total US$54.1m more than the combination of its cash and short-term receivables.
Ranger Energy Services has a market capitalization of US$102.4m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While Ranger Energy Services's low debt to EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.8 last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We also note that Ranger Energy Services improved its EBIT from a last year's loss to a positive US$17m. 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 Ranger Energy Services 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, 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. During the last year, Ranger Energy Services burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
We'd go so far as to say Ranger Energy Services's conversion of EBIT to free cash flow was disappointing. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. Looking at the bigger picture, it seems clear to us that Ranger Energy Services's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Given our hesitation about the stock, it would be good to know if Ranger Energy Services insiders have sold any shares recently. You click here to find out if insiders have sold recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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