Some say that volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett once said that “volatility is far from synonymous with risk.” So it may be obvious that you need to factor in debt when you consider how risky a particular stock is, as too much debt can sink a company. We note that Swan Energy Limited (NSE:SWAN ENERGY) has debts on its balance sheet. But is this debt a concern for shareholders?
What risk does debt entail?
In general, debt only becomes a real problem if a company cannot easily pay it off, either by raising capital or using its own cash flow. An essential part of capitalism is the process of ‘creative destruction’, in which failed companies are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it needs to raise new equity at a low price, permanently diluting shareholders. Debt can, of course, be an important tool in companies, especially in wealthy companies. The first step in considering a company’s debt levels is to consider its cash and debt together.
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What is Swan Energy’s fault?
The image below, which you can click on for more details, shows Swan Energy had debt of 30.4 billion in March 2021, up from 12.1 billion in one year. However, it also had ₹1.11 billion in cash, so the net debt is 29.3 billion.
How strong is Swan Energy’s balance?
According to the last reported balance sheet, Swan Energy had liabilities of 15.1 billion with a maturity of 12 months and liabilities of 20.3 billion with a maturity of more than 12 months. To offset these obligations, it had cash of 1.11 billion and receivables of ₹1.07 billion to be paid within 12 months. It thus has liabilities totaling 33.2 billion more than its cash and short-term receivables combined.
This shortfall is significant relative to its ₹42.8 billion market cap, 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). In this way, we take into account both the absolute amount of the debt and the interest rates paid on it.
Shareholders of Swan Energy are facing the double whammy of a high net debt to EBITDA ratio (43.3) and quite weak interest coverage, as EBIT is only 0.24 times the cost of interest. This means we would view it as heavily indebted. Even worse, Swan Energy saw its EBIT tank 31% over the past 12 months. If long-term earnings continue to rise like this, there’s a snowball opportunity in hell to pay off that debt. 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 revenue to pay off that debt. So when considering debt, it’s definitely worth looking at earnings performance. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we need to see clearly whether that EBIT leads to a corresponding free cash flow. Overall, Swan Energy has seen significant negative free cash flow over the past three years. While investors undoubtedly expect a turnaround in that situation over time, this clearly means that using debt is more risky.
At first glance, Swan Energy’s conversion from EBIT to free cash flow left us hesitant about inventory, and the EBIT growth rate was no more attractive than that one empty restaurant on the busiest night of the year. And on top of that, net debt to EBITDA 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. However, not all investment risks reside within the balance sheet – far from it. For example, Swan Energy has: 3 warning signs (and 2 that cannot be ignored) we think you should know.
At the end of the day, it’s often better to focus on companies that are free of net debt. You can access our special list of such companies (all with a track record of earnings growth). It is free.
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This article from Simply Wall St is general in nature. It is not a recommendation to buy or sell stocks and does not take into account your objectives or your financial situation. We strive to provide you with long-term focused analysis powered by fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or quality material. Simply Wall St has no position in said stocks.
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