David Iben put it well when he said: “Volatility is not a risk we care about. What matters to us is to avoid the permanent loss of capital. ‘ It is only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. Above all, Australis Oil & Gas Limited (ASX: ATS) carries debt. But does this debt concern shareholders?
What risk does debt entail?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. If things really go wrong, lenders can take over the business. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is the debt of Australis Oil & Gas?
As you can see below, Australis Oil & Gas had a debt of US $ 19.1 million in June 2021, up from US $ 22.5 million the year before. However, it has $ 10.2 million in cash offsetting that, which leads to net debt of around $ 8.90 million.
How strong is Australis Oil & Gas’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Australis Oil & Gas had a liability of US $ 14.3 million due within 12 months and a liability of US $ 18.5 million beyond. In compensation for these obligations, it had cash of US $ 10.2 million as well as receivables valued at US $ 3.29 million within 12 months. It therefore has a liability totaling US $ 19.4 million more than its cash and short-term receivables combined.
This deficit is not that big as Australis Oil & Gas is worth US $ 34.8 million, and could therefore probably raise enough capital to consolidate its balance sheet, should the need arise. However, it is always worth taking a close look at your ability to repay your debt.
We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). Thus, we consider debt versus earnings with and without amortization charges.
Even though Australis Oil & Gas debt is only 2.4, its interest coverage is really very low at 0.43. The main reason is that it has such high depreciation and amortization. These charges can be non-monetary, so they could be excluded when it comes to paying off debt. But the accounting fees are there for a reason: some assets lose value. Either way, it’s safe to say that the business has significant debt. We also note that Australis Oil & Gas improved its EBIT from a loss last year to a positive of US $ 960,000. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is future profits, more than anything, that will determine Australis Oil & Gas’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 analyst earnings forecast report interesting.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. It is therefore worth checking to what extent earnings before interest and taxes (EBIT) are backed by free cash flow. Fortunately for all shareholders, Australis Oil & Gas has actually generated more free cash flow than EBIT over the past year. This kind of solid money conversion makes us as excited as the crowd when the beat drops at a Daft Punk concert.
Our point of view
Based on what we have seen, Australis Oil & Gas does not find it easy, given its interest coverage, but the other factors we have taken into account give us cause for optimism. In particular, we are dazzled by its conversion of EBIT into free cash flow. When we consider all of the factors mentioned above, we feel a little cautious about Australis Oil & Gas use of debt. While debt has its advantage in terms of potential higher returns, we believe shareholders should definitely consider how leverage levels might make the stock riskier. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, Australis Oil & Gas has 4 warning signs (and 1 which is of concern) we think you should be aware of.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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