Howard Marks put it nicely when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and every practical investor I know, is worried.’ It seems the smart money knows that debt – which usually comes with bankruptcies – is a very important factor when you assess how risky a company is. important, Swan Energy Limited (NSE:SWAN ENERGY) does bear debt. But should shareholders be concerned about using debt?
When is debt dangerous?
Debt and other obligations become risky for a company when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. 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 needs to raise new equity at a low price, permanently diluting shareholders. That said, the most common situation is for a company to manage its debt fairly well — and for its own benefit. The first thing to do when considering how much debt a company uses is to look at its cash and debt together.
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What is Swan Energy’s Net Debt?
The image below, which you can click on for more details, shows Swan Energy had debt of ₹26.1 billion in September 2020, up from ₹12.1 billion in one year. However, it does have ₹1.21 billion in cash to offset this, leading to a net debt of approximately ₹24.9 billion.
A look at Swan Energy’s commitments
If we zoom in on the latest balance sheet data, we can see that Swan Energy had debts of 16.3 billion due within 12 months and liabilities of ₹16.4 billion thereafter. To offset these commitments, it had cash of 1.21 billion and receivables of ₹1.16 billion, due within 12 months. So his liabilities outweigh the sum of his cash and (current) receivables at 30.3 billion.
This shortfall is significant relative to its market cap of ₹33.8 billion, so it suggests shareholders should keep an eye on Swan Energy’s use of debt. This suggests that shareholders would be highly diluted if the company had to strengthen its balance sheet quickly.
We measure a company’s indebtedness relative to its earning capital by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and by calculating how easily its earnings before interest and taxes (EBIT) offset interest. cover costs (interest cover). So we consider debt in relation to earnings, both with and without depreciation and amortization costs.
Shareholders of Swan Energy are facing the double blow of a high net debt to EBITDA ratio (56.5) and quite weak interest coverage, as EBIT is only 0.68 times the interest expense. The debt burden here is considerable. Another concern for investors could be that Swan Energy’s EBIT is down 11% in the past year. If that’s the way things are going, dealing with the debt load will be like delivering hot coffee on a pogo stick. There is no doubt that we learn the most about debt from the balance sheet. But you can’t see debt completely isolated; as Swan Energy needs income to pay off that debt. So if you want to know more about the earnings, it might be worth checking out this graph of the long-term profit trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the portion of that EBIT that is matched by actual free cash flow. Over the past three years, Swan Energy has burned a lot of money. While that may be the result of spending on growth, it does make debt much more risky.
To be fair, both Swan Energy’s interest rate coverage and track record of converting EBIT to free cash flow make us quite uncomfortable with its debt levels. And on top of that, the EBIT growth rate doesn’t inspire confidence either. Taking into account all the above factors, it seems that Swan Energy has too much debt. While some investors love that kind of risky game, it’s definitely not our thing. There is no doubt that we learn the most about debt from the balance sheet. But in the end, any business can contain risks that exist off-balance sheet. We have identified 1 warning sign with Swan Energy , and understanding them should be part of your investment process.
If you are the type of investor who prefers to buy stocks without debt, don’t hesitate to discover our exclusive list of net cash growth stocks, Today.
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