Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that TransGlobe Energy Corporation ( NASDAQ:TGA ) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does TransGlobe Energy Carry?
The image below, which you can click on for greater detail, shows that TransGlobe Energy had debt of US$48.1m at the end of June 2019, a reduction from US$62.2m over a year. However, it also had US$34.1m in cash, and so its net debt is US$14.0m.
How Strong Is TransGlobe Energy's Balance Sheet?
According to the last reported balance sheet, TransGlobe Energy had liabilities of US$22.4m due within 12 months, and liabilities of US$72.0m due beyond 12 months. On the other hand, it had cash of US$34.1m and US$26.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$33.8m.
While this might seem like a lot, it is not so bad since TransGlobe Energy has a market capitalization of US$104.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
TransGlobe Energy has net debt of just 0.16 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.0 times the interest expense over the last year. It is just as well that TransGlobe Energy's load is not too heavy, because its EBIT was down 28% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if TransGlobe Energy can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts .
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, TransGlobe Energy recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
TransGlobe Energy's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better There's no doubt that its ability to convert EBIT to free cash flow is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about TransGlobe Energy's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that TransGlobe Energy insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link .
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet .
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