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.' 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 can see that Seven Generations Energy Ltd. (TSE:VII) does use debt in its business. But is this debt a concern to shareholders?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Seven Generations Energy's Debt?
The image below, which you can click on for greater detail, shows that Seven Generations Energy had debt of CA$2.04b at the end of June 2019, a reduction from CA$2.19b over a year. However, it does have CA$51.5m in cash offsetting this, leading to net debt of about CA$1.99b.
How Strong Is Seven Generations Energy's Balance Sheet?
According to the last reported balance sheet, Seven Generations Energy had liabilities of CA$419.6m due within 12 months, and liabilities of CA$2.77b due beyond 12 months. Offsetting these obligations, it had cash of CA$51.5m as well as receivables valued at CA$232.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$2.90b.
When you consider that this deficiency exceeds the company's CA$2.27b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With net debt sitting at just 1.0 times EBITDA, Seven Generations Energy is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.4 times the interest expense over the last year. Better yet, Seven Generations Energy grew its EBIT by 115% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Seven Generations 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Seven Generations Energy saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, Seven Generations Energy's level of total liabilities 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 at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Seven Generations Energy'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. Given our hesitation about the stock, it would be good to know if Seven Generations Energy insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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