Is Frontera Energy (TSE:FEC) Using Too Much Debt?

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 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. As with many other companies Frontera Energy Corporation (TSE:FEC) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 Frontera Energy

What Is Frontera Energy's Net Debt?

As you can see below, Frontera Energy had US$517.2m of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$205.6m in cash, and so its net debt is US$311.6m.

How Strong Is Frontera Energy's Balance Sheet?

We can see from the most recent balance sheet that Frontera Energy had liabilities of US$545.4m falling due within a year, and liabilities of US$667.2m due beyond that. On the other hand, it had cash of US$205.6m and US$167.7m worth of receivables due within a year. So its liabilities total US$839.2m more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$473.9m 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 definitely think shareholders need to watch this one closely. At the end of the day, Frontera Energy would probably need a major re-capitalization if its creditors were to demand repayment.

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). 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).

Looking at its net debt to EBITDA of 0.74 and interest cover of 3.3 times, it seems to us that Frontera Energy is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Shareholders should be aware that Frontera Energy's EBIT was down 66% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is Frontera Energy's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Frontera Energy reported free cash flow worth 15% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both Frontera Energy's EBIT growth rate 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 net debt to EBITDA is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think Frontera Energy has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Frontera Energy is showing 2 warning signs in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.