The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies SBM Offshore N.V. (AMS:SBMO) makes use of debt. But the real question is whether this debt is making the company risky.
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
How Much Debt Does SBM Offshore Carry?
You can click the graphic below for the historical numbers, but it shows that SBM Offshore had US$4.54b of debt in June 2019, down from US$4.79b, one year before. On the flip side, it has US$300.0m in cash leading to net debt of about US$4.24b.
How Healthy Is SBM Offshore's Balance Sheet?
The latest balance sheet data shows that SBM Offshore had liabilities of US$1.68b due within a year, and liabilities of US$4.76b falling due after that. Offsetting these obligations, it had cash of US$300.0m as well as receivables valued at US$2.00b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.14b.
Given this deficit is actually higher than the company's market capitalization of US$3.37b, we think shareholders really should watch SBM Offshore'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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
SBM Offshore has a debt to EBITDA ratio of 4.9 and its EBIT covered its interest expense 2.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. On a slightly more positive note, SBM Offshore grew its EBIT at 20% over the last year, further increasing its ability to manage debt. 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 SBM Offshore's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, SBM Offshore actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
SBM Offshore's net debt to EBITDA and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We think that SBM Offshore's debt does make it a bit risky, after considering the aforementioned data points together. 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 SBM Offshore insiders have sold any shares recently. You click here to find out if insiders have sold recently.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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.