Does Zephyr Energy (LON:ZPHR) Have A Healthy Balance Sheet?

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.' 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. Importantly, Zephyr Energy plc (LON:ZPHR) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Our analysis indicates that ZPHR is potentially undervalued!

What Is Zephyr Energy's Debt?

As you can see below, at the end of June 2022, Zephyr Energy had US$28.6m of debt, up from none a year ago. Click the image for more detail. On the flip side, it has US$10.6m in cash leading to net debt of about US$18.0m.

A Look At Zephyr Energy's Liabilities

Zooming in on the latest balance sheet data, we can see that Zephyr Energy had liabilities of US$20.1m due within 12 months and liabilities of US$15.2m due beyond that. Offsetting these obligations, it had cash of US$10.6m as well as receivables valued at US$6.85m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$17.8m.

Since publicly traded Zephyr Energy shares are worth a total of US$121.9m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Zephyr Energy has a low net debt to EBITDA ratio of only 0.81. And its EBIT easily covers its interest expense, being 12.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Although Zephyr Energy made a loss at the EBIT level, last year, it was also good to see that it generated US$15m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Zephyr 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.

Finally, while the tax-man may adore accounting profits, lenders only accept 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. During the last year, Zephyr Energy burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Zephyr Energy's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Zephyr Energy's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more 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. Be aware that Zephyr Energy is showing 3 warning signs in our investment analysis , and 1 of those is significant...

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.