These 4 Measures Indicate That Orbital (ASX:OEC) Is Using Debt Extensively

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.' 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 Orbital Corporation Limited (ASX:OEC) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Orbital

What Is Orbital's Debt?

The image below, which you can click on for greater detail, shows that Orbital had debt of AU$8.89m at the end of December 2020, a reduction from AU$10.7m over a year. However, it does have AU$2.12m in cash offsetting this, leading to net debt of about AU$6.77m.

How Strong Is Orbital's Balance Sheet?

According to the last reported balance sheet, Orbital had liabilities of AU$14.8m due within 12 months, and liabilities of AU$6.50m due beyond 12 months. Offsetting this, it had AU$2.12m in cash and AU$10.3m in receivables that were due within 12 months. So its liabilities total AU$8.93m more than the combination of its cash and short-term receivables.

Given Orbital has a market capitalization of AU$75.1m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

While we wouldn't worry about Orbital's net debt to EBITDA ratio of 3.7, we think its super-low interest cover of 1.8 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, the silver lining was that Orbital achieved a positive EBIT of AU$996k in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Orbital 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. In the last year, Orbital's free cash flow amounted to 20% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Orbital's interest cover was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its level of total liabilities is relatively strong. Taking the abovementioned factors together we do think Orbital's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Orbital (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

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.
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