Some say that volatility, rather than leverage, is the best way for investors to think about risk, but Warren Buffett famously said that “volatility is far from synonymous with risk.” It’s only natural to consider a company’s balance sheet when examining how risky it is, since debt is often at play when a company fails. We note that NewMed Energy – limited partnership (TLV:NWMD) has debt on its balance sheet. But should shareholders be concerned about the use of debt?
Why is debt a risk?
Debt and other liabilities become risky for a company when it cannot easily meet those obligations, either through free cash flow or by raising capital at an attractive rate. If things get really bad, lenders can take control of the deal. However, a more common (but still expensive) situation is when a company has to dilute shareholders at a cheap share price just to get the debt under control. Of course, debt can be an important tool in businesses, especially capital-intensive ones. When examining debt, let’s first look at both cash and debt together.
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What is the fault of NewMed Energy – Limited Partnership?
You can click on the chart below to see historical numbers, but it shows that NewMed Energy – Limited Partnership had $2.21 billion in debt as of June 2022, compared to $3.25 billion a year earlier . However, because it has a cash reserve of $271.6 million, its net debt is smaller at about $1.94 billion.
How healthy is the balance sheet of NewMed Energy – Limited Partnership?
If we take a closer look at the latest balance sheet data, we can see that NewMed Energy – Limited Partnership had $617.1 million in debt due within 12 months and $2.07 billion in debt -Dollars that were due in addition. This was offset by $271.6 million in cash and $350.3 million in receivables due within 12 months. So it has total liabilities of $2.07 billion, more than its cash and short-term receivables combined.
That deficit is sizeable relative to its $3.08 billion market cap, suggesting that shareholders should keep an eye on NewMed Energy – Limited Partnership’s use of debt. This suggests that if the company needed to bolster its balance sheet quickly, shareholders would be severely diluted.
We measure a company’s debt burden relative to its profitability by dividing its net debt by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how well its earnings before interest and taxes (EBIT) are covering its interest costs (interest coverage) . The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio).
NewMed Energy – Limited Partnership has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 3.1 times. Taken together, this means that while we don’t want the debt to increase, we believe it can handle its current leverage. On a lighter level, we note that NewMed Energy – Limited Partnership increased its EBIT by 28% over the past year. If it can sustain that kind of improvement, its debt burden will begin to melt like glaciers in a warming world. Undoubtedly, we learn most about debt from the balance sheet. But it’s NewMed Energy – Limited Partnership’s earnings that will impact its future balance sheet. So when looking at debt, it’s definitely worth looking at earnings performance. Click here for an interactive snapshot.
After all, a business needs free cash flow to pay off debt; Accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that corresponds to actual free cash flow. Over the past three years, NewMed Energy – Limited Partnership’s free cash flow was 46% of its EBIT, less than we expected. This weak cash conversion makes debt management more difficult.
Turning to the balance sheet, the most salient positive for NewMed Energy – Limited Partnership was the fact that it appears to be able to confidently grow its EBIT. But the other factors we mentioned above weren’t so encouraging. For example, his interest coverage makes us a little nervous about his debt. Considering all of the above factors, we are somewhat cautious about NewMed Energy – Limited Partnership’s use of debt capital. While we know that debt can increase returns on equity, we suggest that shareholders keep a close eye on debt levels to keep them from rising. The balance sheet is clearly the area to focus on when analyzing debt. However, the entire investment risk is not on the balance sheet – far from it. For example, NewMed Energy – Limited Partnership 4 warning signs (and 2 that are a bit awkward) that we think you should know about.
Ultimately, sometimes it’s easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with no net debt 100% freeat the moment.
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