David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Trinity Exploration & Production plc (LON:TRIN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Trinity Exploration & Production's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 Trinity Exploration & Production had US$2.70m of debt, an increase on none, over one year. However, it does have US$20.2m in cash offsetting this, leading to net cash of US$17.5m.
How Strong Is Trinity Exploration & Production's Balance Sheet?
The latest balance sheet data shows that Trinity Exploration & Production had liabilities of US$11.8m due within a year, and liabilities of US$48.5m falling due after that. Offsetting this, it had US$20.2m in cash and US$6.38m in receivables that were due within 12 months. So its liabilities total US$33.7m more than the combination of its cash and short-term receivables.
Given Trinity Exploration & Production has a market capitalization of US$892.8m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Trinity Exploration & Production boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact Trinity Exploration & Production's saving grace is its low debt levels, because its EBIT has tanked 67% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Trinity Exploration & Production's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Trinity Exploration & Production has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Trinity Exploration & Production actually produced more free cash flow than EBIT over the last two years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Trinity Exploration & Production has US$17.5m in net cash. The cherry on top was that in converted 336% of that EBIT to free cash flow, bringing in US$4.3m. So we are not troubled with Trinity Exploration & Production's debt use. 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. Be aware that Trinity Exploration & Production is showing 1 warning sign in our investment analysis , you should know about...
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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