Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. As with many other companies Geo Energy Resources Limited (SGX:RE4) makes use of 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. If things get really bad, the lenders can take control of the business. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Geo Energy Resources’s Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Geo Energy Resources had debt of US$292.5m, up from US$293 in one year. On the flip side, it has US$184.5m in cash leading to net debt of about US$108.0m.
How Healthy Is Geo Energy Resources’s Balance Sheet?
According to the last reported balance sheet, Geo Energy Resources had liabilities of US$100.8m due within 12 months, and liabilities of US$299.0m due beyond 12 months. Offsetting these obligations, it had cash of US$184.5m as well as receivables valued at US$31.8m due within 12 months. So it has liabilities totalling US$183.6m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company’s market capitalization of US$150.7m, we think shareholders really should watch Geo Energy Resources’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. 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 Geo Energy Resources 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.
Over 12 months, Geo Energy Resources made a loss at the EBIT level, and saw its revenue drop to US$241m, which is a fall of 28%. To be frank that doesn’t bode well.
Not only did Geo Energy Resources’s revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). To be specific the EBIT loss came in at US$2.0m. Considering that alongside the liabilities mentioned above make us nervous about the company. It would need to improve its operations quickly for us to be interested in it. For example, we would not want to see a repeat of last year’s loss of US$24m. In the meantime, we consider the stock to be risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We’ve identified 2 warning signs with Geo Energy Resources (at least 1 which shouldn’t be ignored) , and understanding them should be part of your investment process.
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.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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