Southern Energy (CVE: SOU) takes risks with its recourse to 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”. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Like many other companies Southern energy company (CVE: SOU) uses debt. But does this debt concern shareholders?
What risk does debt entail?
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) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, debt can be an important tool in businesses, especially capital intensive businesses. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
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What is Southern Energy’s debt?
As you can see below, Southern Energy had a debt of C $ 13.0 million in June 2021, up from C $ 26.0 million the year before. However, given that it has a cash reserve of C $ 2.03 million, its net debt is less, at approximately C $ 10.9 million.
How strong is Southern Energy’s balance sheet?
According to the latest published balance sheet, Southern Energy had liabilities of C $ 10.4 million due within 12 months and liabilities of C $ 16.7 million due beyond 12 months. On the other hand, it had C $ 2.03 million in cash and C $ 2.10 million in receivables due within one year. It therefore has a liability totaling C $ 23.0 million more than its cash and short-term receivables combined.
This deficit is sizable compared to its market capitalization of C $ 23.5 million, so he suggests shareholders keep an eye on Southern Energy’s use of debt. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.
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). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While Southern Energy’s debt-to-EBITDA ratio (3.7) suggests that it is using some debt, its interest coverage is very low at 1.5, suggesting high leverage. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. However, the silver lining was that Southern Energy achieved positive EBIT of C $ 2.7 million over the past twelve months, an improvement over the loss of the previous year. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is future earnings, more than anything, that will determine Southern Energy’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check out this free report showing analysts’ earnings forecasts.
Finally, a business needs free cash flow to repay its debts; accounting profits are not enough. It is therefore worth checking to what extent earnings before interest and taxes (EBIT) are backed by free cash flow. Fortunately for all shareholders, Southern Energy has actually generated more free cash flow than EBIT over the past year. This kind of strong cash generation warms our hearts like a puppy in a bumblebee costume.
Our point of view
Neither Southern Energy’s ability to cover its interest expense with its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But his conversion from EBIT to free cash tells a very different story and suggests some resilience. Taking the above factors together, we believe that Southern Energy’s debt presents certain risks to the business. While this debt may increase returns, we believe the company now has sufficient leverage. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. For example, Southern Energy has 6 warning signs (and 3 that are potentially serious) we think you should be aware of.
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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