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 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 can see that Jadestone Energy Inc. (CVE:JSE) does use debt in its business. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Jadestone Energy's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Jadestone Energy had US$73.4m of debt, an increase on US$13.5m, over one year. However, it also had US$51.9m in cash, and so its net debt is US$21.5m.
How Strong Is Jadestone Energy's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Jadestone Energy had liabilities of US$127.2m due within 12 months and liabilities of US$454.3m due beyond that. Offsetting these obligations, it had cash of US$51.9m as well as receivables valued at US$54.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$475.6m.
Given this deficit is actually higher than the company's market capitalization of US$351.6m, we think shareholders really should watch Jadestone Energy'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.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Jadestone Energy's low debt to EBITDA ratio of 0.22 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.5 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, Jadestone Energy made a loss at the EBIT level, last year, but improved that to positive EBIT of US$36m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Jadestone Energy'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Jadestone Energy actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While Jadestone Energy's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and net debt to EBITDA were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Jadestone Energy is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Given our hesitation about the stock, it would be good to know if Jadestone Energy insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.