The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Eland Oil & Gas PLC (LON:ELA) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.
What Is Eland Oil & Gas's Net Debt?
As you can see below, at the end of December 2018, Eland Oil & Gas had US$47.4m of debt, up from US$25.4m a year ago. Click the image for more detail. However, it does have US$43.1m in cash offsetting this, leading to net debt of about US$4.26m.
How Strong Is Eland Oil & Gas's Balance Sheet?
According to the last reported balance sheet, Eland Oil & Gas had liabilities of US$100.9m due within 12 months, and liabilities of US$58.2m due beyond 12 months. Offsetting this, it had US$43.1m in cash and US$68.7m in receivables that were due within 12 months. So its liabilities total US$47.3m more than the combination of its cash and short-term receivables.
Since publicly traded Eland Oil & Gas shares are worth a total of US$316.6m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Carrying virtually no net debt, Eland Oil & Gas has a very light debt load indeed.
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).
With debt at a measly 0.04 times EBITDA and EBIT covering interest a whopping 17.6 times, it's clear that Eland Oil & Gas is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. Although Eland Oil & Gas made a loss at the EBIT level, last year, it was also good to see that it generated US$79m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Eland Oil & Gas 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Eland Oil & Gas burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Eland Oil & Gas's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Eland Oil & Gas's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Eland Oil & Gas insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.