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. We can see that Caspian Sunrise plc (LON:CASP) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. 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 think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Caspian Sunrise
How Much Debt Does Caspian Sunrise Carry?
The image below, which you can click on for greater detail, shows that at June 2021 Caspian Sunrise had debt of US$5.87m, up from US$5.52m in one year. However, because it has a cash reserve of US$262.0k, its net debt is less, at about US$5.61m.
How Strong Is Caspian Sunrise's Balance Sheet?
We can see from the most recent balance sheet that Caspian Sunrise had liabilities of US$28.4m falling due within a year, and liabilities of US$40.2m due beyond that. On the other hand, it had cash of US$262.0k and US$4.38m worth of receivables due within a year. So its liabilities total US$64.0m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$97.1m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Caspian Sunrise has net debt of just 1.1 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 9.7 times, which is more than adequate. It was also good to see that despite losing money on the EBIT line last year, Caspian Sunrise turned things around in the last 12 months, delivering and EBIT of US$3.4m. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Caspian Sunrise will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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. During the last year, Caspian Sunrise 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.
Our View
Caspian Sunrise's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its interest cover was refreshing. Taking the abovementioned factors together we do think Caspian Sunrise's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Caspian Sunrise that you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.
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About AIM:CASP
Mediocre balance sheet low.