Is SIMEC Atlantis Energy (LON:SAE) Using Too Much Debt?

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.' 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, SIMEC Atlantis Energy Limited (LON:SAE) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for SIMEC Atlantis Energy

What Is SIMEC Atlantis Energy's Net Debt?

As you can see below, SIMEC Atlantis Energy had UK£53.2m of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have UK£2.28m in cash offsetting this, leading to net debt of about UK£50.9m.

How Strong Is SIMEC Atlantis Energy's Balance Sheet?

We can see from the most recent balance sheet that SIMEC Atlantis Energy had liabilities of UK£19.9m falling due within a year, and liabilities of UK£55.0m due beyond that. On the other hand, it had cash of UK£2.28m and UK£6.93m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£65.7m.

This deficit casts a shadow over the UK£8.31m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, SIMEC Atlantis Energy would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Weak interest cover of 1.5 times and a disturbingly high net debt to EBITDA ratio of 7.5 hit our confidence in SIMEC Atlantis Energy like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for SIMEC Atlantis Energy is that it turned last year's EBIT loss into a gain of UK£5.9m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is SIMEC Atlantis Energy's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. In the last year, SIMEC Atlantis Energy's free cash flow amounted to 49% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both SIMEC Atlantis Energy's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. We're quite clear that we consider SIMEC Atlantis Energy to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for SIMEC Atlantis Energy (of which 2 can't be ignored!) you should know about.

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.