Is National Energy Services Reunited (NASDAQ:NESR) 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.' 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, National Energy Services Reunited Corp. (NASDAQ:NESR) does carry 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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for National Energy Services Reunited

What Is National Energy Services Reunited's Debt?

The image below, which you can click on for greater detail, shows that at September 2021 National Energy Services Reunited had debt of US$427.0m, up from US$399.9m in one year. However, because it has a cash reserve of US$101.0m, its net debt is less, at about US$326.0m.

A Look At National Energy Services Reunited's Liabilities

We can see from the most recent balance sheet that National Energy Services Reunited had liabilities of US$368.9m falling due within a year, and liabilities of US$408.6m due beyond that. On the other hand, it had cash of US$101.0m and US$261.1m worth of receivables due within a year. So it has liabilities totalling US$415.5m more than its cash and near-term receivables, combined.

This deficit isn't so bad because National Energy Services Reunited is worth US$886.2m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

National Energy Services Reunited has net debt worth 1.8 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.8 times the interest expense. 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. Shareholders should be aware that National Energy Services Reunited's EBIT was down 21% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if National Energy Services Reunited can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, National Energy Services Reunited recorded free cash flow of 49% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over National Energy Services Reunited's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least its conversion of EBIT to free cash flow is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making National Energy Services Reunited stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. We've identified 3 warning signs with National Energy Services Reunited , and understanding them should be part of your investment process.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.