We Think Independence Contract Drilling (NYSE:ICD) Is Taking Some Risk With Its 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Independence Contract Drilling, Inc. (NYSE:ICD) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

See our latest analysis for Independence Contract Drilling

How Much Debt Does Independence Contract Drilling Carry?

As you can see below, at the end of September 2023, Independence Contract Drilling had US$154.8m of debt, up from US$135.0m a year ago. Click the image for more detail. However, because it has a cash reserve of US$6.04m, its net debt is less, at about US$148.8m.

How Healthy Is Independence Contract Drilling's Balance Sheet?

We can see from the most recent balance sheet that Independence Contract Drilling had liabilities of US$30.8m falling due within a year, and liabilities of US$168.8m due beyond that. Offsetting these obligations, it had cash of US$6.04m as well as receivables valued at US$26.9m due within 12 months. So it has liabilities totalling US$166.7m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$30.5m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Independence Contract Drilling would probably need a major re-capitalization if its creditors were to demand repayment.

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.

While Independence Contract Drilling has a quite reasonable net debt to EBITDA multiple of 2.4, its interest cover seems weak, at 0.58. The main reason for this is that it has such high 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. Either way there's no doubt the stock is using meaningful leverage. We also note that Independence Contract Drilling improved its EBIT from a last year's loss to a positive US$20m. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Independence Contract Drilling can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the most recent year, Independence Contract Drilling recorded free cash flow worth 52% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, Independence Contract Drilling's interest cover 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 conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We're quite clear that we consider Independence Contract Drilling to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example - Independence Contract Drilling has 3 warning signs we think you should be aware of.

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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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.