David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Oceana Group Limited (JSE:OCE) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Oceana Group Carry?
As you can see below, Oceana Group had R3.49b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have R933.6m in cash offsetting this, leading to net debt of about R2.55b.
How Healthy Is Oceana Group's Balance Sheet?
According to the last reported balance sheet, Oceana Group had liabilities of R2.36b due within 12 months, and liabilities of R3.48b due beyond 12 months. Offsetting these obligations, it had cash of R933.6m as well as receivables valued at R1.47b due within 12 months. So it has liabilities totalling R3.43b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Oceana Group has a market capitalization of R6.94b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Oceana Group has net debt worth 1.9 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.7 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Unfortunately, Oceana Group's EBIT flopped 19% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 Oceana Group'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Oceana Group recorded free cash flow worth 62% 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.
Oceana Group's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its conversion of EBIT to free cash flow is relatively strong. When we consider all the factors discussed, it seems to us that Oceana Group is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Oceana Group , and understanding them should be part of your investment process.
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.
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.