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. As with many other companies Subsea 7 S.A. (OB:SUBC) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Subsea 7 Carry?
You can click the graphic below for the historical numbers, but it shows that Subsea 7 had US$221.3m of debt in June 2020, down from US$245.8m, one year before. But it also has US$483.4m in cash to offset that, meaning it has US$262.1m net cash.
A Look At Subsea 7's Liabilities
The latest balance sheet data shows that Subsea 7 had liabilities of US$1.40b due within a year, and liabilities of US$525.1m falling due after that. On the other hand, it had cash of US$483.4m and US$1.06b worth of receivables due within a year. So it has liabilities totalling US$379.4m more than its cash and near-term receivables, combined.
Given Subsea 7 has a market capitalization of US$2.11b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Subsea 7 boasts net cash, so it's fair to say it does not have a heavy debt load!
Importantly, Subsea 7's EBIT fell a jaw-dropping 79% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Subsea 7's ability to maintain a healthy balance sheet going forward. 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. While Subsea 7 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. During the last three years, Subsea 7 generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Although Subsea 7's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$262.1m. And it impressed us with free cash flow of US$293m, being 86% of its EBIT. So we don't have any problem with Subsea 7's use of debt. Even though Subsea 7 lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.
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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