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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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Siem Offshore Inc. (OB:SIOFF) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Siem Offshore

What Is Siem Offshore’s Debt?

You can click the graphic below for the historical numbers, but it shows that Siem Offshore had US$674.0m of debt in September 2021, down from US$1.05b, one year before. On the flip side, it has US$89.6m in cash leading to net debt of about US$584.4m.

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OB:SIOFF Debt to Equity History November 5th 2021

How Strong Is Siem Offshore’s Balance Sheet?

According to the last reported balance sheet, Siem Offshore had liabilities of US$93.8m due within 12 months, and liabilities of US$651.5m due beyond 12 months. Offsetting these obligations, it had cash of US$89.6m as well as receivables valued at US$55.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$600.3m.

This deficit casts a shadow over the US$80.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Siem Offshore would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Siem Offshore shareholders face the double whammy of a high net debt to EBITDA ratio (7.0), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. The debt burden here is substantial. Looking on the bright side, Siem Offshore boosted its EBIT by a silky 79% in the last year. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Siem Offshore’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Siem Offshore actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, Siem Offshore’s interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Once we consider all the factors above, together, it seems to us that Siem Offshore’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. 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. Be aware that Siem Offshore is showing 5 warning signs in our investment analysis , and 2 of those shouldn’t be ignored…

At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.

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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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Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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