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, Frontline Ltd. (NYSE:FRO) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Frontline's Debt?
As you can see below, at the end of June 2020, Frontline had US$2.19b of debt, up from US$1.75b a year ago. Click the image for more detail. However, it also had US$226.3m in cash, and so its net debt is US$1.96b.
A Look At Frontline's Liabilities
The latest balance sheet data shows that Frontline had liabilities of US$666.3m due within a year, and liabilities of US$1.72b falling due after that. Offsetting these obligations, it had cash of US$226.3m as well as receivables valued at US$175.8m due within 12 months. So its liabilities total US$1.98b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$1.30b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Frontline would likely require a major re-capitalisation if it had to pay its creditors today.
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).
Frontline's debt is 2.9 times its EBITDA, and its EBIT cover its interest expense 5.8 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Notably, Frontline's EBIT launched higher than Elon Musk, gaining a whopping 236% on last year. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Frontline's ability to maintain a healthy balance sheet going forward. 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 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. During the last three years, Frontline 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.
To be frank both Frontline's level of total liabilities and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Frontline's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Frontline is showing 4 warning signs in our investment analysis , and 1 of those is significant...
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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