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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Armour Energy Limited (ASX:AJQ) 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for Armour Energy
How Much Debt Does Armour Energy Carry?
The image below, which you can click on for greater detail, shows that at December 2018 Armour Energy had debt of AU$44.6m, up from AU$32.6m in one year. However, it does have AU$7.68m in cash offsetting this, leading to net debt of about AU$36.9m.
A Look At Armour Energy's Liabilities
The latest balance sheet data shows that Armour Energy had liabilities of AU$53.2m due within a year, and liabilities of AU$11.8m falling due after that. Offsetting this, it had AU$7.68m in cash and AU$5.78m in receivables that were due within 12 months. So it has liabilities totalling AU$51.5m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the AU$33.1m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt At the end of the day, Armour Energy would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Armour Energy shareholders face the double whammy of a high net debt to EBITDA ratio (16.7), and fairly weak interest coverage, since EBIT is just 0.11 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Armour Energy is that it turned last year's EBIT loss into a gain of AU$1.0m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Armour Energy's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.