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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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Talos Energy Inc. (NYSE:TALO) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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. 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.
What Is Talos Energy’s Net Debt?
The image below, which you can click on for greater detail, shows that Talos Energy had debt of US$666.4m at the end of March 2019, a reduction from US$776.1m over a year. However, because it has a cash reserve of US$45.7m, its net debt is less, at about US$620.7m.
A Look At Talos Energy’s Liabilities
The latest balance sheet data shows that Talos Energy had liabilities of US$424.6m due within a year, and liabilities of US$1.12b falling due after that. On the other hand, it had cash of US$45.7m and US$151.4m worth of receivables due within a year. So its liabilities total US$1.34b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company’s US$1.34b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Since Talos Energy does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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 Talos Energy’s low debt to EBITDA ratio of 1.02 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.77 last year does give us pause. So we’d recommend keeping a close eye on the impact financing costs are having on the business. Notably, Talos Energy made a loss at the EBIT level, last year, but improved that to positive EBIT of US$265m in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Talos Energy’s ability to maintain a healthy balance sheet going forward. 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 is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Talos Energy recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
We’d go so far as to say Talos Energy’s conversion of EBIT to free cash flow was disappointing. But at least it’s pretty decent at managing its debt, based on its EBITDA,; that’s encouraging. Overall, it seems to us that Talos Energy’s debt load is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on the balance sheet . Given our hesitation about the stock, it would be good to know if Talos Energy insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.