Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Ocean Yield ASA (OB:OCY) does use debt in its business. But the real question is whether this debt is making the company risky.
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Ocean Yield
What Is Ocean Yield's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Ocean Yield had debt of US$1.93b, up from US$1.59b in one year. However, because it has a cash reserve of US$86.9m, its net debt is less, at about US$1.84b.
A Look At Ocean Yield's Liabilities
Zooming in on the latest balance sheet data, we can see that Ocean Yield had liabilities of US$390.2m due within 12 months and liabilities of US$1.62b due beyond that. On the other hand, it had cash of US$86.9m and US$12.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.91b.
This deficit casts a shadow over the US$897.1m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Ocean Yield would probably need a major re-capitalization if its creditors were to demand repayment.
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.
Weak interest cover of 1.6 times and a disturbingly high net debt to EBITDA ratio of 8.0 hit our confidence in Ocean Yield like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Ocean Yield's EBIT was down 33% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Ocean Yield can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.