Is Armour Energy (ASX:AJQ) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Armour Energy Limited (ASX:AJQ) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Armour Energy

What Is Armour Energy's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Armour Energy had AU$37.5m of debt in June 2021, down from AU$54.8m, one year before. However, because it has a cash reserve of AU$2.36m, its net debt is less, at about AU$35.1m.

A Look At Armour Energy's Liabilities

Zooming in on the latest balance sheet data, we can see that Armour Energy had liabilities of AU$23.5m due within 12 months and liabilities of AU$31.6m due beyond that. Offsetting these obligations, it had cash of AU$2.36m as well as receivables valued at AU$2.10m due within 12 months. So it has liabilities totalling AU$50.6m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of AU$46.4m, we think shareholders really should watch Armour Energy'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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Armour Energy's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Over 12 months, Armour Energy made a loss at the EBIT level, and saw its revenue drop to AU$18m, which is a fall of 17%. We would much prefer see growth.

Caveat Emptor

Not only did Armour Energy's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Its EBIT loss was a whopping AU$22m. When we look at that alongside the significant liabilities, we're not particularly confident about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it burned through AU$23m in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Armour Energy (of which 2 are significant!) you should know about.

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.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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