Zephyr Energy (LON:ZPHR) Has A Somewhat Strained Balance Sheet

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Zephyr Energy plc (LON:ZPHR) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Zephyr Energy

How Much Debt Does Zephyr Energy Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 Zephyr Energy had US$4.06m of debt, an increase on none, over one year. However, it does have US$1.81m in cash offsetting this, leading to net debt of about US$2.25m.

How Strong Is Zephyr Energy's Balance Sheet?

We can see from the most recent balance sheet that Zephyr Energy had liabilities of US$9.47m falling due within a year, and liabilities of US$508.0k due beyond that. On the other hand, it had cash of US$1.81m and US$1.26m worth of receivables due within a year. So its liabilities total US$6.91m more than the combination of its cash and short-term receivables.

Since publicly traded Zephyr Energy shares are worth a total of US$86.3m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Zephyr Energy's low debt to EBITDA ratio of 0.98 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.9 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We also note that Zephyr Energy improved its EBIT from a last year's loss to a positive US$531k. When analysing debt levels, the balance sheet is the obvious place to start. 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. Over the last year, Zephyr Energy saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Zephyr Energy's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to handle its debt, based on its EBITDA, isn't too shabby at all. Looking at all the angles mentioned above, it does seem to us that Zephyr Energy is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. For example, we've discovered 4 warning signs for Zephyr Energy (1 shouldn't be ignored!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.