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David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Southwestern Energy Company (NYSE:SWN) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Southwestern Energy Carry?
As you can see below, Southwestern Energy had US$2.32b of debt at March 2019, down from US$4.39b a year prior. On the flip side, it has US$367.0m in cash leading to net debt of about US$1.95b.
How Strong Is Southwestern Energy’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Southwestern Energy had liabilities of US$943.0m due within 12 months and liabilities of US$2.57b due beyond that. Offsetting this, it had US$367.0m in cash and US$390.0m in receivables that were due within 12 months. So it has liabilities totalling US$2.75b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$1.37b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Southwestern Energy would probably need a major re-capitalization if its creditors were to demand repayment. Because it carries more debt than cash, we think it’s worth watching Southwestern Energy’s balance sheet over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Southwestern Energy has net debt of just 1.44 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.25 times the interest expense over the last year. Unfortunately, Southwestern Energy’s EBIT flopped 20% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Southwestern Energy 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Southwestern Energy actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
To be frank both Southwestern Energy’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at covering its interest expense with its EBIT; that’s encouraging. After considering the datapoints discussed, we think Southwestern Energy 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 Southwestern Energy’s use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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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. Thank you for reading.