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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Aker BP ASA (OB:AKERBP) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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 Aker BP’s Debt?
The image below, which you can click on for greater detail, shows that Aker BP had debt of US$2.66b at the end of June 2019, a reduction from US$3.03b over a year. However, it does have US$101.8m in cash offsetting this, leading to net debt of about US$2.56b.
How Strong Is Aker BP’s Balance Sheet?
We can see from the most recent balance sheet that Aker BP had liabilities of US$1.39b falling due within a year, and liabilities of US$7.44b due beyond that. On the other hand, it had cash of US$101.8m and US$336.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$8.39b.
This is a mountain of leverage relative to its market capitalization of US$9.31b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Aker BP’s net debt is only 1.1 times its EBITDA. And its EBIT covers its interest expense a whopping 26.0 times over. So we’re pretty relaxed about its super-conservative use of debt. Fortunately, Aker BP grew its EBIT by 6.9% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Aker BP 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Aker BP generated free cash flow amounting to a very robust 86% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Both Aker BP’s ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. Considering this range of data points, we think Aker BP is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. We’d be motivated to research the stock further if we found out that Aker BP insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
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.
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