Does Source Energy Services (TSE:SHLE) Have A Healthy Balance Sheet?

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 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 Source Energy Services Ltd. (TSE:SHLE) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Source Energy Services

What Is Source Energy Services's Net Debt?

The chart below, which you can click on for greater detail, shows that Source Energy Services had CA$163.1m in debt in September 2024; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Source Energy Services' Balance Sheet?

We can see from the most recent balance sheet that Source Energy Services had liabilities of CA$244.1m falling due within a year, and liabilities of CA$82.1m due beyond that. Offsetting this, it had CA$910.0k in cash and CA$68.6m in receivables that were due within 12 months. So it has liabilities totalling CA$256.8m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CA$210.6m, we think shareholders really should watch Source Energy Services'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.

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.

While Source Energy Services has a quite reasonable net debt to EBITDA multiple of 2.1, its interest cover seems weak, at 2.0. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Importantly, Source Energy Services grew its EBIT by 64% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Source Energy Services'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Source Energy Services actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Both Source Energy Services's ability to to convert EBIT to free cash flow and its EBIT growth rate gave us comfort that it can handle its debt. But truth be told its interest cover had us nibbling our nails. When we consider all the factors mentioned above, we do feel a bit cautious about Source Energy Services's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more 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. To that end, you should be aware of the 3 warning signs we've spotted with Source Energy Services .

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.