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”. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We can see that Forage Orbite Garant Inc. (TSE: OGD) uses debt in his business. But the real question is whether this debt makes the business risky.
When is debt dangerous?
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. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. 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 Orbit Garant Drilling’s net debt?
The graph below, which you can click for more details, shows that Orbit Garant Drilling had a debt of C $ 35.3 million as of June 2021; about the same as the year before. However, given that it has a cash reserve of C $ 3.26 million, its net debt is less, at approximately C $ 32.0 million.
How strong is Orbit Garant Drilling’s balance sheet?
The latest balance sheet data shows Orbit Garant Drilling had C $ 36.5 million in debt due within one year, and C $ 31.3 million in debt due thereafter. In return, he had C $ 3.26 million in cash and C $ 41.8 million in receivables due within 12 months. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by C $ 22.7 million.
This shortfall is not that big of a deal as Orbit Garant Drilling is worth C $ 41.1 million, and could therefore probably raise enough capital to consolidate its balance sheet, should the need arise. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
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). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
While Orbit Garant Drilling’s debt / EBITDA ratio (2.6) suggests that it uses some debt, its interest coverage is very low at 1.1, suggesting high leverage. This is in large part due to the company’s significant 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. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. A buyout factor for Orbit Garant Drilling is that it turned last year’s loss of EBIT into a gain of C $ 2.6 million over the past twelve months. There is no doubt that we learn the most about debt from the balance sheet. But it is future profits, more than anything, that will determine Orbit Garant Drilling’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. It is therefore worth checking to what extent earnings before interest and taxes (EBIT) are backed by free cash flow. In the most recent year, Orbit Garant Drilling recorded free cash flow of 74% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
Orbit Garant Drilling’s interest coverage was a real negative on this analysis, although other factors we took into account cast it in a much better light. In particular, its conversion of EBIT into free cash flow was revitalized. We think Orbit Garant Drilling’s debt makes it a bit risky, having considered the aforementioned data points together. This isn’t necessarily a bad thing, as leverage can increase returns on equity, but it’s something to be aware of. The balance sheet is clearly the area you need to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. To this end, you should inquire about the 3 warning signs we spotted with Orbit Garant Drilling (including 1 which is significant).
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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