Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Archer Limited (OB:ARCHER) does carry debt. But should shareholders be worried about its use of debt?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
What Is Archer’s Debt?
You can click the graphic below for the historical numbers, but it shows that Archer had US$615.7m of debt in June 2019, down from US$651.6m, one year before. However, because it has a cash reserve of US$35.7m, its net debt is less, at about US$580.0m.
How Healthy Is Archer’s Balance Sheet?
The latest balance sheet data shows that Archer had liabilities of US$207.3m due within a year, and liabilities of US$616.0m falling due after that. Offsetting these obligations, it had cash of US$35.7m as well as receivables valued at US$148.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$639.5m.
The deficiency here weighs heavily on the US$66.3m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt At the end of the day, Archer would probably need a major re-capitalization if its creditors were to demand repayment.
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.
Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 6.1 hit our confidence in Archer like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. However, the silver lining was that Archer achieved a positive EBIT of US$44m in the last twelve months, an improvement on the prior year’s loss. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Archer’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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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 most recent year, Archer recorded free cash flow worth 74% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
On the face of it, Archer’s interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. We’re quite clear that we consider Archer 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. Given our hesitation about the stock, it would be good to know if Archer insiders have sold any shares recently. You click here to find out if insiders have sold recently.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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