Forum Energy Technologies (NYSE:FET) Takes On Some Risk With Its Use Of 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. We can see that Forum Energy Technologies, Inc. (NYSE:FET) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Forum Energy Technologies

What Is Forum Energy Technologies's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Forum Energy Technologies had US$128.5m of debt in September 2023, down from US$247.5m, one year before. However, it does have US$37.2m in cash offsetting this, leading to net debt of about US$91.4m.

How Healthy Is Forum Energy Technologies' Balance Sheet?

We can see from the most recent balance sheet that Forum Energy Technologies had liabilities of US$208.3m falling due within a year, and liabilities of US$203.5m due beyond that. Offsetting this, it had US$37.2m in cash and US$167.0m in receivables that were due within 12 months. So it has liabilities totalling US$207.6m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of US$240.4m. 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 Forum Energy Technologies has a quite reasonable net debt to EBITDA multiple of 1.6, its interest cover seems weak, at 0.97. In large part that's it has so much depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. Notably, Forum Energy Technologies made a loss at the EBIT level, last year, but improved that to positive EBIT of US$21m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Forum Energy Technologies 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. In the last year, Forum Energy Technologies created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

We'd go so far as to say Forum Energy Technologies's interest cover was disappointing. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. Overall, we think it's fair to say that Forum Energy Technologies 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. 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. Be aware that Forum Energy Technologies is showing 1 warning sign in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.