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 can see that Frontline Ltd. (NYSE:FRO) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. 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. 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 step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Frontline Carry?
As you can see below, Frontline had US$1.72b of debt at March 2019, down from US$2.02b a year prior. However, it also had US$96.8m in cash, and so its net debt is US$1.62b.
How Strong Is Frontline’s Balance Sheet?
We can see from the most recent balance sheet that Frontline had liabilities of US$226.4m falling due within a year, and liabilities of US$1.69b due beyond that. Offsetting these obligations, it had cash of US$96.8m as well as receivables valued at US$126.6m due within 12 months. So it has liabilities totalling US$1.69b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s US$1.20b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 6.5 hit our confidence in Frontline like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. The silver lining is that Frontline grew its EBIT by 200% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Frontline can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Frontline burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Frontline’s net debt to EBITDA 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 EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that Frontline’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Over time, share prices tend to follow earnings per share, so if you’re interested in Frontline, you may well want to click here to check an interactive graph of its earnings per share history.
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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