Santos (ASX: STO) takes risks with its use of debt
Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a 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. We can see that Santos Limited (ASX: STO) uses debt in his business. But does this debt worry shareholders?
When is debt dangerous?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, especially capital intensive businesses. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
Check out our latest analysis for Santos
How much debt does Santos have?
The image below, which you can click for more details, shows that as of June 2021, Santos was in debt of $ 5.22 billion, up from $ 4.66 billion in a year. However, it has $ 2.42 billion in cash offsetting that, leading to net debt of around $ 2.80 billion.
How strong is Santos’ balance sheet?
Zooming in on the latest balance sheet data, we can see that Santos had a liability of US $ 1.71 billion due within 12 months and a liability of US $ 9.49 billion beyond. On the other hand, he had $ 2.42 billion in cash and $ 703.0 million in receivables due within one year. Its liabilities therefore total US $ 8.08 billion more than the combination of its cash and short-term receivables.
This deficit is sizable compared to its very large market capitalization of US $ 11.2 billion, so he suggests shareholders keep an eye on Santos’ use of debt. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Santos has net debt of 1.6 times EBITDA, which isn’t too much, but its interest coverage looks a bit weak, with EBIT at just 4.1 times interest expense. This is in large part due to the company’s large depreciation and amortization charges, which arguably means that its EBITDA is a very generous measure of profit, and its debt may be heavier than it appears. At first glance. The bad news is that Santos has seen its EBIT drop by 17% in the past year. If this kind of decline is not stopped, managing your debt will be more difficult than selling broccoli ice cream at a higher price. The balance sheet is clearly the area you need to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Santos can strengthen its balance sheet over time. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Fortunately for all shareholders, Santos has actually generated more free cash flow than EBIT over the past three years. This kind of strong cash generation warms our hearts like a puppy in a bumblebee costume.
Our point of view
Santos’ EBIT growth rate and total liability level certainly weighs on this, in our view. But the good news is that it seems to be able to easily convert EBIT into free cash flow. When we consider all the factors mentioned, it seems to us that Santos is taking risks with its recourse to debt. So while this leverage increases returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. For example – Santos has 1 warning sign we think you should be aware.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
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 the mentioned stocks.
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