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 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 can see that Talos Energy Inc. (NYSE:TALO) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. 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.
What Is Talos Energy's Debt?
You can click the graphic below for the historical numbers, but it shows that Talos Energy had US$788.5m of debt in June 2022, down from US$982.6m, one year before. However, it also had US$108.5m in cash, and so its net debt is US$680.0m.
How Healthy Is Talos Energy's Balance Sheet?
According to the last reported balance sheet, Talos Energy had liabilities of US$701.3m due within 12 months, and liabilities of US$1.26b due beyond 12 months. Offsetting these obligations, it had cash of US$108.5m as well as receivables valued at US$282.2m due within 12 months. So it has liabilities totalling US$1.57b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of US$1.78b, so it does suggest shareholders should keep an eye on Talos Energy's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Talos Energy's low debt to EBITDA ratio of 0.88 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.5 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, Talos Energy made a loss at the EBIT level, last year, but improved that to positive EBIT of US$320m in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Talos Energy's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Talos Energy recorded free cash flow worth a fulsome 85% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Our View
On our analysis Talos Energy's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, interest cover gives us cold feet. Looking at all this data makes us feel a little cautious about Talos Energy's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example Talos Energy has 2 warning signs (and 1 which is significant) we think you should know about.
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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