Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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 Offshore Limited (OB:BWO) does use debt in its business. But the real question is whether this debt is making the company risky.
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is BW Offshore’s Net Debt?
The chart below, which you can click on for greater detail, shows that BW Offshore had US$1.33b in debt in March 2019; about the same as the year before. However, it also had US$177.0m in cash, and so its net debt is US$1.15b.
A Look At BW Offshore’s Liabilities
According to the last reported balance sheet, BW Offshore had liabilities of US$868.3m due within 12 months, and liabilities of US$1.19b due beyond 12 months. On the other hand, it had cash of US$177.0m and US$247.9m worth of receivables due within a year. So it has liabilities totalling US$1.64b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$965.7m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, BW Offshore 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.
Even though BW Offshore’s debt is only 2.0, its interest cover is really very low at 2.5. The main reason for this is that it has such high depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there’s no doubt the stock is using meaningful leverage. It is well worth noting that BW Offshore’s EBIT shot up like bamboo after rain, gaining 51% in the last twelve months. That’ll make it easier to manage its debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if BW Offshore 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last two years, BW Offshore’s free cash flow amounted to 33% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
Mulling over BW Offshore’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that BW Offshore’s use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Over time, share prices tend to follow earnings per share, so if you’re interested in BW Offshore, you may well want to click here to check an interactive graph of its earnings per share history.
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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