These 4 metrics indicate that Frontline (NYSE:FRO) is using debt in a risky way

Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. Like many other companies Frontline Ltd. (NYSE:FRO) uses debt. But should shareholders worry about its use of debt?

When is debt a problem?

Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first thing to do when considering how much debt a business has is to look at its cash and debt together.

See our latest analysis for Frontline

What is Frontline Debt?

You can click on the graph below for historical numbers, but it shows that in March 2022, Frontline had $2.23 billion in debt, an increase from $2.13 billion, year-over-year . On the other hand, he has $113.9 million in cash, resulting in a net debt of around $2.12 billion.

NYSE:FRO Debt to Equity July 5, 2022

How strong is Frontline’s balance sheet?

We can see from the most recent balance sheet that Frontline had liabilities of US$538.1 million due in one year, and liabilities of US$1.84 billion due beyond. As compensation for these obligations, it had cash of US$113.9 million and receivables valued at US$140.3 million due within 12 months. It therefore has liabilities totaling $2.12 billion more than its cash and short-term receivables, combined.

When you consider that shortfall exceeds the company’s US$2.01 billion market capitalization, you might well be inclined to take a close look at the balance sheet. In theory, extremely large dilution would be required if the company were forced to repay its debts by raising capital at the current share price.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).

Low interest coverage of 0.034 times and an extremely high net debt to EBITDA ratio of 14.5 hit our confidence in Frontline like a punch in the gut. The debt burden here is considerable. Worse still, Frontline’s EBIT is down 100% year over year. If profits continue like this in the long term, there is an unimaginable chance of repaying this debt. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine Frontline’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, while the taxman may love accounting profits, lenders only accept cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Frontline has experienced substantial negative free cash flow, in total. While investors no doubt expect a reversal of this situation in due course, this clearly means that its use of debt is more risky.

Our point of view

To be frank, Frontline’s conversion of EBIT to free cash flow and its history of (no) growth in its EBIT make us rather uncomfortable with its level of leverage. And even its net debt to EBITDA doesn’t inspire much confidence. We think the chances of Frontline having too much debt are very high. For us, this means that the action is rather high risk, and probably to be avoided; but everyone has their own (investment) style. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. To do this, you need to find out about the 3 warning signs we spotted with Frontline (including 1 that should not be overlooked).

If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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