U.S. Markets open in 6 hrs 46 mins

PHX Energy Services (TSE:PHX) Takes On Some Risk With Its Use Of Debt

Simply Wall St

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. We note that PHX Energy Services Corp. (TSE:PHX) 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?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for PHX Energy Services

What Is PHX Energy Services's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2019 PHX Energy Services had CA$22.9m of debt, an increase on CA$15.2m, over one year. However, it does have CA$7.41m in cash offsetting this, leading to net debt of about CA$15.5m.

TSX:PHX Historical Debt, August 26th 2019

A Look At PHX Energy Services's Liabilities

We can see from the most recent balance sheet that PHX Energy Services had liabilities of CA$64.8m falling due within a year, and liabilities of CA$59.8m due beyond that. Offsetting this, it had CA$7.41m in cash and CA$80.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$36.7m.

While this might seem like a lot, it is not so bad since PHX Energy Services has a market capitalization of CA$140.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

PHX Energy Services has a very low debt to EBITDA ratio of 0.38 so it is strange to see weak interest coverage, with last year's EBIT being only 0.67 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Notably, PHX Energy Services made a loss at the EBIT level, last year, but improved that to positive EBIT of CA$1.7m in the last twelve months. 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 PHX 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, PHX Energy Services burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, PHX Energy Services's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that PHX Energy Services's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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 editorial-team@simplywallst.com. 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.