Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Enerflex Ltd. (TSE:EFX) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Enerflex Carry?
You can click the graphic below for the historical numbers, but it shows that Enerflex had CA$362.1m of debt in March 2021, down from CA$474.4m, one year before. On the flip side, it has CA$110.6m in cash leading to net debt of about CA$251.5m.
How Strong Is Enerflex's Balance Sheet?
According to the last reported balance sheet, Enerflex had liabilities of CA$269.4m due within 12 months, and liabilities of CA$464.8m due beyond 12 months. On the other hand, it had cash of CA$110.6m and CA$266.0m worth of receivables due within a year. So its liabilities total CA$357.6m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Enerflex has a market capitalization of CA$730.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Enerflex's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 3.4 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, Enerflex's EBIT fell a jaw-dropping 73% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Enerflex can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Enerflex reported free cash flow worth 5.8% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
We'd go so far as to say Enerflex's EBIT growth rate was disappointing. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. We're quite clear that we consider Enerflex to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Enerflex has 1 warning sign we think you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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