Does Santos (ASX:STO) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Santos Limited (ASX:STO) makes use of debt. But should shareholders be worried about its use of debt?

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.

Check out our latest analysis for Santos

How Much Debt Does Santos Carry?

As you can see below, at the end of December 2023, Santos had US$5.37b of debt, up from US$4.67b a year ago. Click the image for more detail. On the flip side, it has US$2.13b in cash leading to net debt of about US$3.25b.

How Strong Is Santos' Balance Sheet?

According to the last reported balance sheet, Santos had liabilities of US$2.95b due within 12 months, and liabilities of US$11.5b due beyond 12 months. Offsetting these obligations, it had cash of US$2.13b as well as receivables valued at US$932.0m due within 12 months. So it has liabilities totalling US$11.4b more than its cash and near-term receivables, combined.

This is a mountain of leverage even relative to its gargantuan market capitalization of US$16.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Santos has a low net debt to EBITDA ratio of only 0.91. And its EBIT covers its interest expense a whopping 34.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Santos's load is not too heavy, because its EBIT was down 41% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Santos's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Santos generated free cash flow amounting to a very robust 80% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Santos's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Santos's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 2 warning signs with Santos , 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. 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.