Is Sound Energy (LON:SOU) Using Debt In A Risky Way?

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. As with many other companies Sound Energy plc (LON:SOU) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

View our latest analysis for Sound Energy

How Much Debt Does Sound Energy Carry?

As you can see below, at the end of December 2023, Sound Energy had UK£33.3m of debt, up from UK£30.2m a year ago. Click the image for more detail. On the flip side, it has UK£3.02m in cash leading to net debt of about UK£30.3m.

How Strong Is Sound Energy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sound Energy had liabilities of UK£2.82m due within 12 months and liabilities of UK£34.7m due beyond that. Offsetting this, it had UK£3.02m in cash and UK£924.0k in receivables that were due within 12 months. So it has liabilities totalling UK£33.6m more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the UK£16.9m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Sound Energy would likely require a major re-capitalisation if it had to pay its creditors today. 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 Sound Energy will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Given its lack of meaningful operating revenue, Sound Energy shareholders no doubt hope it can fund itself until it can sell some combustibles.

Caveat Emptor

Importantly, Sound Energy had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost a very considerable UK£2.4m at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it burned through UK£4.6m in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. 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. We've identified 4 warning signs with Sound Energy (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.