Is SM Energy (NYSE:SM) A Risky Investment?

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 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 SM Energy Company (NYSE:SM) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

How Much Debt Does SM Energy Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2024 SM Energy had US$2.78b of debt, an increase on US$1.58b, over one year. However, because it has a cash reserve of US$1.74b, its net debt is less, at about US$1.04b.

How Strong Is SM Energy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that SM Energy had liabilities of US$790.0m due within 12 months and liabilities of US$3.55b due beyond that. Offsetting this, it had US$1.74b in cash and US$361.0m in receivables that were due within 12 months. So its liabilities total US$2.24b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of US$3.51b, so it does suggest shareholders should keep an eye on SM Energy's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

See our latest analysis for SM Energy

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt sitting at just 0.55 times EBITDA, SM Energy is arguably pretty conservatively geared. And it boasts interest cover of 9.9 times, which is more than adequate. Fortunately, SM Energy grew its EBIT by 9.0% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if SM Energy 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, 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. Considering the last three years, SM Energy actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

SM Energy's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its net debt to EBITDA was refreshing. We think that SM Energy's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 SM Energy has 3 warning signs (and 2 which are a bit concerning) 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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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.