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Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Trinity Exploration & Production plc (LON:TRIN) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Trinity Exploration & Production's Debt?
The chart below, which you can click on for greater detail, shows that Trinity Exploration & Production had US$2.70m in debt in June 2021; about the same as the year before. However, its balance sheet shows it holds US$19.0m in cash, so it actually has US$16.3m net cash.
How Strong Is Trinity Exploration & Production's Balance Sheet?
According to the last reported balance sheet, Trinity Exploration & Production had liabilities of US$14.0m due within 12 months, and liabilities of US$48.9m due beyond 12 months. Offsetting this, it had US$19.0m in cash and US$8.23m in receivables that were due within 12 months. So it has liabilities totalling US$35.7m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Trinity Exploration & Production is worth US$83.6m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Trinity Exploration & Production also has more cash than debt, so we're pretty confident it can manage its debt safely.
Although Trinity Exploration & Production made a loss at the EBIT level, last year, it was also good to see that it generated US$1.3m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Trinity Exploration & Production's ability to maintain a healthy balance sheet going forward. 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. Trinity Exploration & Production may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Considering the last year, Trinity Exploration & Production actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
While Trinity Exploration & Production does have more liabilities than liquid assets, it also has net cash of US$16.3m. So although we see some areas for improvement, we're not too worried about Trinity Exploration & Production's balance sheet. 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 Trinity Exploration & Production is showing 2 warning signs in our investment analysis , you should know about...
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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