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.' 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 Seplat Petroleum Development Company Plc (LON:SEPL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Seplat Petroleum Development's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2021 Seplat Petroleum Development had US$753.7m of debt, an increase on US$692.8m, over one year. On the flip side, it has US$273.9m in cash leading to net debt of about US$479.8m.
How Healthy Is Seplat Petroleum Development's Balance Sheet?
According to the last reported balance sheet, Seplat Petroleum Development had liabilities of US$395.3m due within 12 months, and liabilities of US$1.42b due beyond 12 months. Offsetting these obligations, it had cash of US$273.9m as well as receivables valued at US$284.4m due within 12 months. So it has liabilities totalling US$1.26b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$684.4m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Seplat Petroleum Development would likely require a major re-capitalisation if it had to pay its creditors today.
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 Seplat Petroleum Development has a quite reasonable net debt to EBITDA multiple of 1.8, its interest cover seems weak, at 2.4. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. The bad news is that Seplat Petroleum Development saw its EBIT decline by 17% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Seplat Petroleum Development can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Seplat Petroleum Development recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
To be frank both Seplat Petroleum Development's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider Seplat Petroleum Development to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 3 warning signs for Seplat Petroleum Development you should be aware of, and 1 of them is a bit unpleasant.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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.
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