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. 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 Pyxis Tankers Inc. (NASDAQ:PXS) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Pyxis Tankers’s Debt?
You can click the graphic below for the historical numbers, but it shows that Pyxis Tankers had US$63.2m of debt in December 2019, down from US$67.5m, one year before. However, because it has a cash reserve of US$1.44m, its net debt is less, at about US$61.8m.
How Strong Is Pyxis Tankers’s Balance Sheet?
We can see from the most recent balance sheet that Pyxis Tankers had liabilities of US$22.5m falling due within a year, and liabilities of US$54.2m due beyond that. Offsetting these obligations, it had cash of US$1.44m as well as receivables valued at US$1.24m due within 12 months. So it has liabilities totalling US$74.1m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$20.2m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt. After all, Pyxis Tankers would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Weak interest cover of 0.039 times and a disturbingly high net debt to EBITDA ratio of 11.1 hit our confidence in Pyxis Tankers like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for Pyxis Tankers is that it turned last year’s EBIT loss into a gain of US$228k, over the last twelve months. 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 Pyxis Tankers 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Pyxis Tankers actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
To be frank both Pyxis Tankers’s interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that Pyxis Tankers’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. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we’ve identified 2 warning signs for Pyxis Tankers that you should be aware of.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.