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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, SilverBow Resources, Inc. (NYSE:SBOW) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does SilverBow Resources Carry?
As you can see below, at the end of June 2022, SilverBow Resources had US$640.2m of debt, up from US$393.4m a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.
A Look At SilverBow Resources' Liabilities
According to the last reported balance sheet, SilverBow Resources had liabilities of US$273.1m due within 12 months, and liabilities of US$706.0m due beyond 12 months. Offsetting this, it had US$9.41m in cash and US$84.1m in receivables that were due within 12 months. So it has liabilities totalling US$885.6m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's US$687.5m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
SilverBow Resources's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 4.9 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Pleasingly, SilverBow Resources is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 251% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine SilverBow Resources'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, SilverBow Resources 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
On the face of it, SilverBow Resources's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that SilverBow Resources's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 5 warning signs for SilverBow Resources (2 are potentially serious) you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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