Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Nabors Industries Ltd. (NYSE:NBR) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Nabors Industries Carry?
The image below, which you can click on for greater detail, shows that Nabors Industries had debt of US$2.54b at the end of December 2022, a reduction from US$3.26b over a year. However, it does have US$452.3m in cash offsetting this, leading to net debt of about US$2.09b.
A Look At Nabors Industries’ Liabilities
Zooming in on the latest balance sheet data, we can see that Nabors Industries had liabilities of US$596.4m due within 12 months and liabilities of US$2.92b due beyond that. Offsetting these obligations, it had cash of US$452.3m as well as receivables valued at US$351.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.71b.
The deficiency here weighs heavily on the US$1.09b 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, Nabors Industries would probably need a major re-capitalization if its creditors were to demand repayment.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While Nabors Industries’s debt to EBITDA ratio (2.9) suggests that it uses some debt, its interest cover is very weak, at 0.27, suggesting high leverage. In large part that’s due to the company’s significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, the silver lining was that Nabors Industries achieved a positive EBIT of US$44m in the last twelve months, an improvement on the prior year’s loss. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Nabors Industries can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Nabors Industries actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
To be frank both Nabors Industries’s interest cover 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 converting EBIT to free cash flow; that’s encouraging. Looking at the bigger picture, it seems clear to us that Nabors Industries’s use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt.