Does FAR-EASTERN ENERGY (MCX:DVEC) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Public joint stock company FAR-EASTERN ENERGY COMPANY (MCX:DVEC) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for FAR-EASTERN ENERGY

How Much Debt Does FAR-EASTERN ENERGY Carry?

As you can see below, FAR-EASTERN ENERGY had ₽14.2b of debt at December 2020, down from ₽91.5b a year prior. However, it does have ₽6.30b in cash offsetting this, leading to net debt of about ₽7.88b.

A Look At FAR-EASTERN ENERGY's Liabilities

We can see from the most recent balance sheet that FAR-EASTERN ENERGY had liabilities of ₽21.2b falling due within a year, and liabilities of ₽18.2b due beyond that. On the other hand, it had cash of ₽6.30b and ₽9.15b worth of receivables due within a year. So its liabilities total ₽24.0b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the ₽13.7b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, FAR-EASTERN ENERGY would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

FAR-EASTERN ENERGY has a low net debt to EBITDA ratio of only 0.23. And its EBIT easily covers its interest expense, being 60.3 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that FAR-EASTERN ENERGY's load is not too heavy, because its EBIT was down 27% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is FAR-EASTERN ENERGY'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, FAR-EASTERN ENERGY burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, FAR-EASTERN ENERGY's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. It's also worth noting that FAR-EASTERN ENERGY is in the Electric Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that FAR-EASTERN ENERGY's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example FAR-EASTERN ENERGY has 2 warning signs (and 1 which can't be ignored) we think you should know about.

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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