BW Energy (OB:BWE) 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.' 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 BW Energy Limited (OB:BWE) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for BW Energy

What Is BW Energy's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2023 BW Energy had debt of US$192.8m, up from none in one year. However, it does have US$166.4m in cash offsetting this, leading to net debt of about US$26.4m.

A Look At BW Energy's Liabilities

The latest balance sheet data shows that BW Energy had liabilities of US$194.8m due within a year, and liabilities of US$443.9m falling due after that. On the other hand, it had cash of US$166.4m and US$34.5m worth of receivables due within a year. So it has liabilities totalling US$437.8m more than its cash and near-term receivables, combined.

This deficit isn't so bad because BW Energy is worth US$741.3m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While BW Energy's low debt to EBITDA ratio of 0.30 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.7 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly, BW Energy's EBIT fell a jaw-dropping 60% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if BW Energy 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, BW Energy burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both BW Energy's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. We're quite clear that we consider BW Energy to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - BW Energy has 1 warning sign we think you should be aware of.

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.