Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Talos Energy Inc. (NYSE:TALO) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Talos Energy's Debt?
As you can see below, Talos Energy had US$788.5m of debt at June 2022, down from US$982.6m a year prior. However, it also had US$108.5m in cash, and so its net debt is US$680.0m.
How Healthy Is Talos Energy's Balance Sheet?
We can see from the most recent balance sheet that Talos Energy had liabilities of US$701.3m falling due within a year, and liabilities of US$1.26b due beyond that. Offsetting these obligations, it had cash of US$108.5m as well as receivables valued at US$282.2m due within 12 months. So it has liabilities totalling US$1.57b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of US$1.30b, we think shareholders really should watch Talos Energy's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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).
While Talos Energy's low debt to EBITDA ratio of 0.88 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.5 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We also note that Talos Energy improved its EBIT from a last year's loss to a positive US$320m. When analysing debt levels, the balance sheet is the obvious place to start. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Talos Energy generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Neither Talos Energy's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We think that Talos Energy's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example Talos Energy has 2 warning signs (and 1 which shouldn't be ignored) we think you should know about.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.
Talos Energy Inc., an independent exploration and production company, focuses on the exploration and production of oil and natural gas properties in the United States Gulf of Mexico and offshore Mexico.
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Undervalued with proven track record.