Is STEP Energy Services (TSE:STEP) A Risky Investment?

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.' 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. Importantly, STEP Energy Services Ltd. (TSE:STEP) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 STEP Energy Services

How Much Debt Does STEP Energy Services Carry?

The image below, which you can click on for greater detail, shows that STEP Energy Services had debt of CA$140.8m at the end of December 2022, a reduction from CA$190.0m over a year. Net debt is about the same, since the it doesn't have much cash.

A Look At STEP Energy Services' Liabilities

We can see from the most recent balance sheet that STEP Energy Services had liabilities of CA$189.8m falling due within a year, and liabilities of CA$186.7m due beyond that. Offsetting this, it had CA$2.79m in cash and CA$199.1m in receivables that were due within 12 months. So its liabilities total CA$174.6m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of CA$255.7m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

STEP Energy Services has net debt of just 0.82 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 7.1 times, which is more than adequate. It was also good to see that despite losing money on the EBIT line last year, STEP Energy Services turned things around in the last 12 months, delivering and EBIT of CA$90m. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if STEP Energy Services can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. In the last year, STEP Energy Services's free cash flow amounted to 44% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither STEP Energy Services's ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But it seems to be able handle its debt, based on its EBITDA, without much trouble. Looking at all the angles mentioned above, it does seem to us that STEP Energy Services is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. We've identified 4 warning signs with STEP Energy Services (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

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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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.