Is Stampede Drilling (CVE:SDI) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. Importantly, Stampede Drilling Inc. (CVE:SDI) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 Stampede Drilling

What Is Stampede Drilling's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Stampede Drilling had CA$11.3m of debt in March 2022, down from CA$12.8m, one year before. However, it also had CA$601.0k in cash, and so its net debt is CA$10.7m.

How Strong Is Stampede Drilling's Balance Sheet?

According to the last reported balance sheet, Stampede Drilling had liabilities of CA$12.1m due within 12 months, and liabilities of CA$4.32m due beyond 12 months. Offsetting this, it had CA$601.0k in cash and CA$7.58m in receivables that were due within 12 months. So it has liabilities totalling CA$8.24m more than its cash and near-term receivables, combined.

Given Stampede Drilling has a market capitalization of CA$64.8m, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Stampede Drilling's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 2.8 times last year. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. Notably, Stampede Drilling made a loss at the EBIT level, last year, but improved that to positive EBIT of CA$1.9m in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Stampede Drilling'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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Stampede Drilling actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Happily, Stampede Drilling's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But the stark truth is that we are concerned by its interest cover. Looking at all the aforementioned factors together, it strikes us that Stampede Drilling can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Stampede Drilling that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.