Warren Buffett said: “Volatility is far from synonymous with risk”. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. Above all, Shelf Drilling, Ltd. (OB: SHLF) carries a debt. But the most important question is: what risk does this debt create?

When is Debt a Problem?

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 painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. 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. When we look at debt levels, we first look at cash and debt levels, together.

See our latest review for Shelf Drilling

What is Shelf Drilling’s net debt?

As you can see below, at the end of September 2021, Shelf Drilling was in debt of $ 1.19 billion, up from $ 1.02 billion a year ago. Click on the image for more details. However, he also had $ 251.3 million in cash, so his net debt is $ 940.0 million.

A look at the responsibilities of Shelf Drilling

The latest balance sheet data shows that Shelf Drilling had debts of US $ 137.3 million due within one year, and debts of US $ 1.24 billion due thereafter. In compensation for these obligations, he had cash of US $ 251.3 million as well as receivables valued at US $ 110.9 million maturing within 12 months. Its liabilities therefore total US $ 1.02 billion more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the $ 93.9 million company as a towering colossus of mere mortals. We would therefore monitor its record closely, without a doubt. Ultimately, Shelf Drilling would likely need a major recapitalization if its creditors demanded repayment.

We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we look at debt versus earnings with and without amortization expenses.

Low interest coverage of 0.41 times and an extremely high Net Debt to EBITDA ratio of 8.9 hit our confidence in Shelf Drilling like a punch in the stomach. This means that we would consider him to be in heavy debt. Worse yet, Shelf Drilling has seen its EBIT reach 57% over the past 12 months. If profits continue to follow this path, it will be more difficult to pay off this debt than to convince us to run a marathon in the rain. 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 Shelf 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.

Finally, a business can only pay off its debts with hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past two years, Shelf Drilling has experienced substantial total negative free cash flow. While investors no doubt expect this situation to reverse in due course, this clearly means its use of debt is riskier.

Our point of view

To be frank, Shelf Drilling’s EBIT growth rate and its history of staying above its total liabilities make us rather uncomfortable with its debt levels. And what’s more, his interest coverage fails to inspire confidence either. It seems to us that Shelf Drilling weighs heavily on the balance sheet. If you harvest honey without a bee costume, you might get stung, so we’ll probably stay away from that particular stock. When analyzing debt levels, the balance sheet is the obvious place to start. However, not all investment risks lie on the balance sheet – far from it. Concrete example: we have spotted 3 warning signs for Shelf Drilling you need to be aware of it, and one of them is a little rude.

Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash net growth stocks today.

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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 any stock 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 any of the stocks mentioned.