Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. We note that ConocoPhillips Company (NYSE:COP) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is ConocoPhillips’s Debt?
As you can see below, at the end of September 2019, ConocoPhillips had US$14.2b of debt, up from US$15.0k a year ago. Click the image for more detail. However, it does have US$10.1b in cash offsetting this, leading to net debt of about US$4.13b.
How Healthy Is ConocoPhillips’s Balance Sheet?
We can see from the most recent balance sheet that ConocoPhillips had liabilities of US$5.94b falling due within a year, and liabilities of US$29.2b due beyond that. Offsetting this, it had US$10.1b in cash and US$3.62b in receivables that were due within 12 months. So it has liabilities totalling US$21.4b more than its cash and near-term receivables, combined.
ConocoPhillips has a very large market capitalization of US$71.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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).
ConocoPhillips’s net debt is only 0.29 times its EBITDA. And its EBIT covers its interest expense a whopping 11.7 times over. So we’re pretty relaxed about its super-conservative use of debt. On the other hand, ConocoPhillips saw its EBIT drop by 9.5% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 ConocoPhillips’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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, ConocoPhillips produced sturdy free cash flow equating to 70% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that ConocoPhillips’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its EBIT growth rate. Looking at all the aforementioned factors together, it strikes us that ConocoPhillips can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of ConocoPhillips’s earnings per share history for free.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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. Thank you for reading.