Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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 Seplat Petroleum Development Company Plc (LON:SEPL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Seplat Petroleum Development Carry?
You can click the graphic below for the historical numbers, but it shows that Seplat Petroleum Development had US$356.5m of debt in September 2019, down from US$536.9m, one year before. But on the other hand it also has US$454.7m in cash, leading to a US$98.2m net cash position.
How Healthy Is Seplat Petroleum Development's Balance Sheet?
The latest balance sheet data shows that Seplat Petroleum Development had liabilities of US$292.3m due within a year, and liabilities of US$482.9m falling due after that. On the other hand, it had cash of US$454.7m and US$139.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$181.6m.
While this might seem like a lot, it is not so bad since Seplat Petroleum Development has a market capitalization of US$879.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Seplat Petroleum Development boasts net cash, so it's fair to say it does not have a heavy debt load!
But the other side of the story is that Seplat Petroleum Development saw its EBIT decline by 4.8% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Seplat Petroleum Development's ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. Seplat Petroleum Development may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Seplat Petroleum Development actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Although Seplat Petroleum Development's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$98.2m. The cherry on top was that in converted 175% of that EBIT to free cash flow, bringing in US$298m. So we are not troubled with Seplat Petroleum Development's debt use. Given Seplat Petroleum Development has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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