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David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Seven Generations Energy Ltd. (TSE:VII) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. 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. 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 step when considering a company’s debt levels is to consider its cash and debt together.
What Is Seven Generations Energy’s Net Debt?
The chart below, which you can click on for greater detail, shows that Seven Generations Energy had CA$2.09b in debt in March 2019; about the same as the year before. Net debt is about the same, since the it doesn’t have much cash.
A Look At Seven Generations Energy’s Liabilities
Zooming in on the latest balance sheet data, we can see that Seven Generations Energy had liabilities of CA$517.6m due within 12 months and liabilities of CA$2.84b due beyond that. Offsetting these obligations, it had cash of CA$32.3m as well as receivables valued at CA$303.9m due within 12 months. So it has liabilities totalling CA$3.02b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s CA$2.27b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Because it carries more debt than cash, we think it’s worth watching Seven Generations Energy’s balance sheet over time.
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.
Looking at its net debt to EBITDA of 1.21 and interest cover of 6.85 times, it seems to us that Seven Generations 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. Another good sign is that Seven Generations Energy has been able to increase its EBIT by 28% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Seven Generations Energy’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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Seven Generations Energy burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, Seven Generations Energy’s level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Seven Generations Energy stock a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if Seven Generations Energy insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.