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 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 UK Oil & Gas PLC (LON:UKOG) makes use of debt. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is UK Oil & Gas's Net Debt?
The image below, which you can click on for greater detail, shows that at March 2021 UK Oil & Gas had debt of UK£3.09m, up from none in one year. However, because it has a cash reserve of UK£1.94m, its net debt is less, at about UK£1.14m.
How Strong Is UK Oil & Gas' Balance Sheet?
According to the last reported balance sheet, UK Oil & Gas had liabilities of UK£6.36m due within 12 months, and liabilities of UK£1.03m due beyond 12 months. Offsetting these obligations, it had cash of UK£1.94m as well as receivables valued at UK£2.47m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£2.97m.
Since publicly traded UK Oil & Gas shares are worth a total of UK£31.7m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. There's no doubt that we learn most about debt from the balance sheet. But it is UK Oil & Gas'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.
In the last year UK Oil & Gas wasn't profitable at an EBIT level, but managed to grow its revenue by 678%, to UK£1.5m. When it comes to revenue growth, that's like nailing the game winning 3-pointer!
While we can certainly appreciate UK Oil & Gas's revenue growth, its earnings before interest and tax (EBIT) loss is not ideal. Its EBIT loss was a whopping UK£18m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled UK£3.4m in negative free cash flow over the last twelve months. So suffice it to say we consider the stock very risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 6 warning signs for UK Oil & Gas you should be aware of, and 2 of them are a bit concerning.
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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