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.’ 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 can see that Oryx Petroleum Corporation Limited (TSE:OXC) does use debt in its business. But the real question is whether this debt is making the company risky.
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 examine debt levels, we first consider both cash and debt levels, together.
What Is Oryx Petroleum’s Debt?
As you can see below, Oryx Petroleum had US$80.8m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$18.1m, its net debt is less, at about US$62.7m.
How Healthy Is Oryx Petroleum’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Oryx Petroleum had liabilities of US$64.2m due within 12 months and liabilities of US$142.3m due beyond that. Offsetting this, it had US$18.1m in cash and US$25.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$163.4m.
The deficiency here weighs heavily on the US$105.3m 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, Oryx Petroleum 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Looking at its net debt to EBITDA of 0.69 and interest cover of 6.3 times, it seems to us that Oryx Petroleum is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Although Oryx Petroleum made a loss at the EBIT level, last year, it was also good to see that it generated US$73m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Oryx Petroleum will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Oryx Petroleum reported free cash flow worth 9.4% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Mulling over Oryx Petroleum’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But at least it’s pretty decent at managing its debt, based on its EBITDA,; that’s encouraging. Overall, it seems to us that Oryx Petroleum’s balance sheet is really quite a risk to the business. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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