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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. We can see that Seplat Petroleum Development Company Plc (LON:SEPL) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Seplat Petroleum Development’s Net Debt?
As you can see below, Seplat Petroleum Development had US$341.7m of debt at March 2019, down from US$536.4m a year prior. However, it does have US$649.8m in cash offsetting this, leading to net cash of US$308.1m.
A Look At Seplat Petroleum Development’s Liabilities
The latest balance sheet data shows that Seplat Petroleum Development had liabilities of US$469.2m due within a year, and liabilities of US$478.1m falling due after that. On the other hand, it had cash of US$649.8m and US$146.6m worth of receivables due within a year. So it has liabilities totalling US$150.8m more than its cash and near-term receivables, combined.
Since publicly traded Seplat Petroleum Development shares are worth a total of US$817.0m, 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. Seplat Petroleum Development boasts net cash, so it’s fair to say it does not have a heavy debt load!
In addition to that, we’re happy to report that Seplat Petroleum Development has boosted its EBIT by 51%, thus reducing the spectre of future debt repayments. 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 Seplat Petroleum Development’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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. Seplat Petroleum Development may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, Seplat Petroleum Development actually produced more free cash flow than EBIT over the last two years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Although Seplat Petroleum Development’s balance sheet isn’t particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$308m. And it impressed us with free cash flow of US$433m, being 180% of its EBIT. So is Seplat Petroleum Development’s debt a risk? It doesn’t seem so to us. We’d be very excited to see if Seplat Petroleum Development insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.