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.' 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 Reach Subsea ASA (OB:REACH) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Reach Subsea's Net Debt?
The image below, which you can click on for greater detail, shows that Reach Subsea had debt of kr15.0m at the end of June 2020, a reduction from kr20.0m over a year. However, its balance sheet shows it holds kr57.3m in cash, so it actually has kr42.3m net cash.
How Healthy Is Reach Subsea's Balance Sheet?
According to the last reported balance sheet, Reach Subsea had liabilities of kr284.6m due within 12 months, and liabilities of kr31.4m due beyond 12 months. Offsetting these obligations, it had cash of kr57.3m as well as receivables valued at kr178.0m due within 12 months. So it has liabilities totalling kr80.6m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Reach Subsea is worth kr234.0m, 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. Despite its noteworthy liabilities, Reach Subsea boasts net cash, so it's fair to say it does not have a heavy debt load!
Shareholders should be aware that Reach Subsea's EBIT was down 43% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Reach Subsea will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Reach Subsea has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Reach Subsea actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Although Reach Subsea's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of kr42.3m. And it impressed us with free cash flow of kr185m, being 1,222% of its EBIT. So although we see some areas for improvement, we're not too worried about Reach Subsea's balance sheet. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Reach Subsea (at least 1 which is significant) , and understanding them should be part of your investment process.
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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