Is Aker BP (OB:AKRBP) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Aker BP ASA (OB:AKRBP) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Aker BP

What Is Aker BP's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Aker BP had US$5.75b of debt, an increase on US$5.20b, over one year. However, it also had US$3.38b in cash, and so its net debt is US$2.38b.

A Look At Aker BP's Liabilities

We can see from the most recent balance sheet that Aker BP had liabilities of US$5.58b falling due within a year, and liabilities of US$20.0b due beyond that. On the other hand, it had cash of US$3.38b and US$1.49b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$20.7b.

When you consider that this deficiency exceeds the company's huge US$18.3b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Aker BP's net debt is only 0.19 times its EBITDA. And its EBIT easily covers its interest expense, being 176 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Aker BP has been able to increase its EBIT by 23% in twelve months, making it easier to pay down debt. 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 Aker BP's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Aker BP recorded free cash flow of 42% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Both Aker BP's ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. Looking at all this data makes us feel a little cautious about Aker BP's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For example - Aker BP has 2 warning signs we think you should be aware of.

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.