Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Frontline Ltd. (NYSE:FRO) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Frontline’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2021 Frontline had US$2.26b of debt, an increase on US$2.16b, over one year. However, because it has a cash reserve of US$124.9m, its net debt is less, at about US$2.13b.
How Healthy Is Frontline’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Frontline had liabilities of US$267.5m due within 12 months and liabilities of US$2.14b due beyond that. On the other hand, it had cash of US$124.9m and US$101.7m worth of receivables due within a year. So it has liabilities totalling US$2.18b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$1.32b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Frontline would likely require a major re-capitalisation if it had to pay its creditors today. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Frontline’s ability to maintain a healthy balance sheet going forward.
In the last year Frontline had a loss before interest and tax, and actually shrunk its revenue by 49%, to US$711m. To be frank that doesn’t bode well.
Not only did Frontline’s revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost US$8.3m at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. We’d want to see some strong near-term improvements before getting too interested in the stock. Not least because it burned through US$163m in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. The balance sheet is clearly the area to focus on when you are analysing debt.