Seplat Petroleum Development (LON: SEPL) has a somewhat strained balance sheet

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Legendary fund manager Li Lu (who Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We notice that Seplat Petroleum Development Company Plc (LON: SEPL) has debt on its balance sheet. But should shareholders be concerned about its use of debt?

When is debt a problem?

Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. 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, many companies use debt to finance their growth without negative consequences. When we look at debt levels, we first consider both cash and debt levels.

Discover our latest analysis for Seplat Petroleum Development

What is Seplat Petroleum Development’s debt?

As you can see below, Seplat Petroleum Development had $ 694.4 million in debt in March 2021, up from $ 793.9 million the year before. However, he also had $ 236.3 million in cash, so his net debt is $ 458.1 million.

LSE: SEPL History of debt to equity July 2, 2021

A look at the liabilities of Seplat Petroleum Development

Zooming in on the latest balance sheet data, we can see that Seplat Petroleum Development had a liability of $ 424.5 million due within 12 months and a liability of $ 1.34 billion due beyond. In compensation for these obligations, it had cash of US $ 236.3 million as well as receivables valued at US $ 274.5 million within 12 months. Its liabilities therefore total $ 1.26 billion more than the combination of its cash and short-term receivables.

The lack here weighs heavily on the $ 777.3 million business itself, as if a child struggles under the weight of a huge backpack full of books, his gym equipment, and a trumpet. . So we would be watching its record closely, without a doubt. In the end, Seplat Petroleum Development would probably need a major recapitalization if its creditors demanded repayment.

In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). Thus, we consider debt versus earnings with and without amortization charges.

While we are not worried about Seplat Petroleum Development’s net debt to EBITDA ratio of 2.6, we believe its ultra-low interest coverage of 0.87 times is a sign of high leverage. It appears that the company incurs significant depreciation and amortization costs, so perhaps its debt load is heavier than it first appears, since EBITDA is arguably a generous measure of profits. Shareholders should therefore probably be aware that interest charges seem to have had a real impact on the company in recent times. It is important to note that Seplat Petroleum Development’s EBIT has fallen 88% over the past twelve months. If this earnings trend continues, paying off debt will be about as easy as driving cats on a roller coaster. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Seplat Petroleum Development 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, a business can only pay off its debts with hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Fortunately for all shareholders, Seplat Petroleum Development 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

To be frank, Seplat Petroleum Development’s EBIT growth rate and its history of staying above its total liabilities make us rather uncomfortable with its debt levels. But on the positive side, its conversion from EBIT to free cash flow is a good sign and makes us more optimistic. Overall, it seems to us that Seplat Petroleum Development’s balance sheet is really very risky for the company. We are therefore almost as wary of this stock as a hungry kitten falls into its owner’s fish pond: once bitten, twice shy, as they say. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 4 warning signs for Seplat Petroleum Development (1 of which is a bit disturbing!) that you should know about.

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. 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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