The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 is this debt a concern to shareholders?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Reach Subsea Carry?
The image below, which you can click on for greater detail, shows that Reach Subsea had debt of kr20.0m at the end of June 2019, a reduction from kr262.3m over a year. However, it does have kr51.4m in cash offsetting this, leading to net cash of kr31.4m.
How Healthy Is Reach Subsea’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Reach Subsea had liabilities of kr274.8m due within 12 months and liabilities of kr122.4m due beyond that. Offsetting this, it had kr51.4m in cash and kr167.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr178.6m.
This deficit is considerable relative to its market capitalization of kr287.1m, so it does suggest shareholders should keep an eye on Reach Subsea’s use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, Reach Subsea boasts net cash, so it’s fair to say it does not have a heavy debt load!
Notably, Reach Subsea’s EBIT launched higher than Elon Musk, gaining a whopping 100% on last year. There’s no doubt that we learn most about debt from the balance sheet. But it is Reach Subsea’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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. Over the last three years, Reach Subsea actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
While Reach Subsea does have more liabilities than liquid assets, it also has net cash of kr31.4m. And it impressed us with free cash flow of kr246m, being 1011% of its EBIT. So we are not troubled with Reach Subsea’s debt use. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Reach Subsea insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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