Is Far-Eastern Shipping (MCX:FESH) Using Too Much Debt?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Far-Eastern Shipping Company PLC. (MCX:FESH) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Far-Eastern Shipping

How Much Debt Does Far-Eastern Shipping Carry?

As you can see below, Far-Eastern Shipping had ₽33.2b of debt at June 2020, down from ₽35.2b a year prior. However, because it has a cash reserve of ₽2.99b, its net debt is less, at about ₽30.2b.

How Strong Is Far-Eastern Shipping's Balance Sheet?

The latest balance sheet data shows that Far-Eastern Shipping had liabilities of ₽16.6b due within a year, and liabilities of ₽30.1b falling due after that. Offsetting this, it had ₽2.99b in cash and ₽8.38b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₽35.4b.

This deficit is considerable relative to its market capitalization of ₽35.4b, so it does suggest shareholders should keep an eye on Far-Eastern Shipping's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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 Far-Eastern Shipping's net debt to EBITDA ratio of 3.2, we think its super-low interest cover of 1.8 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even more troubling is the fact that Far-Eastern Shipping actually let its EBIT decrease by 5.3% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Far-Eastern Shipping 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, 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. Looking at the most recent three years, Far-Eastern Shipping recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over Far-Eastern Shipping's attempt at covering its interest expense with its EBIT, we're certainly not enthusiastic. But at least its conversion of EBIT to free cash flow is not so bad. Overall, we think it's fair to say that Far-Eastern Shipping has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Far-Eastern Shipping has 2 warning signs (and 1 which is significant) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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