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Transocean (NYSE:RIG) Seems To Be Using An Awful Lot Of Debt

Simply Wall St

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Transocean Ltd. (NYSE:RIG) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Transocean

What Is Transocean's Debt?

The chart below, which you can click on for greater detail, shows that Transocean had US$9.73b in debt in June 2019; about the same as the year before. However, it also had US$2.24b in cash, and so its net debt is US$7.48b.

NYSE:RIG Historical Debt, September 16th 2019

A Look At Transocean's Liabilities

According to the last reported balance sheet, Transocean had liabilities of US$1.46b due within 12 months, and liabilities of US$11.4b due beyond 12 months. Offsetting this, it had US$2.24b in cash and US$645.0m in receivables that were due within 12 months. So it has liabilities totalling US$9.98b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$3.51b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, Transocean would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.16 times and a disturbingly high net debt to EBITDA ratio of 6.9 hit our confidence in Transocean like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Transocean's EBIT was down 59% 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Transocean 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.

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. Over the last three years, Transocean actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On the face of it, Transocean's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Taking into account all the aforementioned factors, it looks like Transocean has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given the risks around Transocean's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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.