Warren Buffett famously said, '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. Importantly, Scorpio Bulkers Inc. (NYSE:SALT) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Scorpio Bulkers's Debt?
The image below, which you can click on for greater detail, shows that Scorpio Bulkers had debt of US$441.6m at the end of September 2019, a reduction from US$790.4m over a year. However, because it has a cash reserve of US$80.1m, its net debt is less, at about US$361.4m.
How Healthy Is Scorpio Bulkers's Balance Sheet?
According to the last reported balance sheet, Scorpio Bulkers had liabilities of US$114.4m due within 12 months, and liabilities of US$751.0m due beyond 12 months. Offsetting this, it had US$80.1m in cash and US$11.5m in receivables that were due within 12 months. So it has liabilities totalling US$773.7m more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$446.8m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, Scorpio Bulkers would likely require a major re-capitalisation if it had to pay its creditors today.
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.
While we wouldn't worry about Scorpio Bulkers's net debt to EBITDA ratio of 4.5, we think its super-low interest cover of 0.47 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Scorpio Bulkers's EBIT was down 33% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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 Scorpio Bulkers'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last two years, Scorpio Bulkers burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Scorpio Bulkers's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. Considering everything we've mentioned above, it's fair to say that Scorpio Bulkers is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Scorpio Bulkers's earnings per share history for free.
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.
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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.