Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 can see that Top Ships Inc. (NASDAQ:TOPS) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Top Ships’s Debt?
The image below, which you can click on for greater detail, shows that Top Ships had debt of US$227.2m at the end of June 2023, a reduction from US$244.5m over a year. However, it does have US$9.63m in cash offsetting this, leading to net debt of about US$217.6m.
How Healthy Is Top Ships’ Balance Sheet?
We can see from the most recent balance sheet that Top Ships had liabilities of US$57.4m falling due within a year, and liabilities of US$203.2m due beyond that. Offsetting these obligations, it had cash of US$9.63m as well as receivables valued at US$622.0k due within 12 months. So it has liabilities totalling US$250.4m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$11.2m 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’d watch its balance sheet closely, without a doubt. At the end of the day, Top Ships would probably need a major re-capitalization if its creditors were to demand repayment.
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.
While Top Ships’s debt to EBITDA ratio (4.5) suggests that it uses some debt, its interest cover is very weak, at 1.9, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Looking on the bright side, Top Ships boosted its EBIT by a silky 32% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Top Ships can strengthen its balance sheet over time.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Top Ships saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Top Ships’s conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Overall, it seems to us that Top Ships’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There’s no doubt that we learn most about debt from the balance sheet.