The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Liberty Energy Inc. (NYSE:LBRT) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Liberty Energy's Debt?
The image below, which you can click on for greater detail, shows that at June 2022 Liberty Energy had debt of US$254.0m, up from US$105.6m in one year. However, it does have US$41.5m in cash offsetting this, leading to net debt of about US$212.5m.
How Strong Is Liberty Energy's Balance Sheet?
According to the last reported balance sheet, Liberty Energy had liabilities of US$622.1m due within 12 months, and liabilities of US$383.0m due beyond 12 months. Offsetting this, it had US$41.5m in cash and US$564.0m in receivables that were due within 12 months. So its liabilities total US$399.6m more than the combination of its cash and short-term receivables.
Of course, Liberty Energy has a market capitalization of US$2.60b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Given net debt is only 0.68 times EBITDA, it is initially surprising to see that Liberty Energy's EBIT has low interest coverage of 1.3 times. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that Liberty Energy improved its EBIT from a last year's loss to a positive US$22m. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Liberty Energy's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Liberty Energy saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
Both Liberty Energy's conversion of EBIT to free cash flow and its interest cover were discouraging. But on the brighter side of life, its net debt to EBITDA leaves us feeling more frolicsome. Taking the abovementioned factors together we do think Liberty Energy's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Liberty Energy you should know about.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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