Is Genesis Energy (NZSE:GNE) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, Genesis Energy Limited (NZSE:GNE) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Genesis Energy

What Is Genesis Energy's Debt?

The chart below, which you can click on for greater detail, shows that Genesis Energy had NZ$1.30b in debt in June 2020; about the same as the year before. However, because it has a cash reserve of NZ$32.5m, its net debt is less, at about NZ$1.27b.

How Healthy Is Genesis Energy's Balance Sheet?

According to the last reported balance sheet, Genesis Energy had liabilities of NZ$301.3m due within 12 months, and liabilities of NZ$2.21b due beyond 12 months. Offsetting these obligations, it had cash of NZ$32.5m as well as receivables valued at NZ$260.0m due within 12 months. So its liabilities total NZ$2.22b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of NZ$3.55b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While we wouldn't worry about Genesis Energy's net debt to EBITDA ratio of 3.8, we think its super-low interest cover of 2.2 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Investors should also be troubled by the fact that Genesis Energy saw its EBIT drop by 13% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Genesis 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 it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Genesis Energy actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Neither Genesis Energy's ability to cover its interest expense with its EBIT nor its EBIT growth rate gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We should also note that Electric Utilities industry companies like Genesis Energy commonly do use debt without problems. Taking the abovementioned factors together we do think Genesis Energy's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Genesis Energy has 2 warning signs we think you should be aware of.

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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