Here's Why CGG (EPA:CGG) Has A Meaningful Debt Burden

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies CGG (EPA:CGG) makes use of debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for CGG

How Much Debt Does CGG Carry?

You can click the graphic below for the historical numbers, but it shows that CGG had US$1.19b of debt in March 2022, down from US$1.25b, one year before. However, it also had US$389.8m in cash, and so its net debt is US$795.7m.

How Strong Is CGG's Balance Sheet?

According to the last reported balance sheet, CGG had liabilities of US$578.5m due within 12 months, and liabilities of US$1.31b due beyond 12 months. Offsetting this, it had US$389.8m in cash and US$278.3m in receivables that were due within 12 months. So it has liabilities totalling US$1.22b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$916.9m, we think shareholders really should watch CGG's debt levels, like a parent watching their child ride a bike for the first time. 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While CGG has a quite reasonable net debt to EBITDA multiple of 1.6, its interest cover seems weak, at 1.2. In large part that's it has so much depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. We also note that CGG improved its EBIT from a last year's loss to a positive US$135m. 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 CGG'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, CGG recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

On the face of it, CGG's level of total liabilities left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that CGG's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Be aware that CGG is showing 1 warning sign 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.