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. As with many other companies Tsakos Energy Navigation Limited (NYSE:TNP) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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, 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.
What Is Tsakos Energy Navigation’s Net Debt?
As you can see below, Tsakos Energy Navigation had US$1.54b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$160.5m in cash, and so its net debt is US$1.38b.
A Look At Tsakos Energy Navigation’s Liabilities
We can see from the most recent balance sheet that Tsakos Energy Navigation had liabilities of US$382.0m falling due within a year, and liabilities of US$1.35b due beyond that. Offsetting these obligations, it had cash of US$160.5m as well as receivables valued at US$46.1m due within 12 months. So its liabilities total US$1.52b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$159.0m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Tsakos Energy Navigation would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
Tsakos Energy Navigation has a rather high debt to EBITDA ratio of 5.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.6 times, suggesting it can responsibly service its obligations. However, one redeeming factor is that Tsakos Energy Navigation grew its EBIT at 17% over the last 12 months, boosting its ability to handle its debt. 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 Tsakos Energy Navigation’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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Tsakos Energy Navigation recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
To be frank both Tsakos Energy Navigation’s net debt to EBITDA 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. Looking at the bigger picture, it seems clear to us that Tsakos Energy Navigation’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. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet.