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 note that Parsley Energy, Inc. (NYSE:PE) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
See our latest analysis for Parsley Energy
What Is Parsley Energy’s Debt?
The chart below, which you can click on for greater detail, shows that Parsley Energy had US$2.22b in debt in June 2019; about the same as the year before. However, because it has a cash reserve of US$64.1m, its net debt is less, at about US$2.16b.
A Look At Parsley Energy’s Liabilities
The latest balance sheet data shows that Parsley Energy had liabilities of US$789.3m due within a year, and liabilities of US$2.62b falling due after that. Offsetting these obligations, it had cash of US$64.1m as well as receivables valued at US$190.1m due within 12 months. So its liabilities total US$3.16b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Parsley Energy is worth US$5.37b, and thus could probably raise enough capital to shore up 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 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.
Parsley Energy has net debt worth 1.6 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 4.0 times the interest expense. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It is well worth noting that Parsley Energy’s EBIT shot up like bamboo after rain, gaining 38% in the last twelve months. That’ll make it easier to manage 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 Parsley Energy’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Parsley Energy burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
Parsley Energy’s conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Parsley Energy is a somewhat risky investment as a result of its debt. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Given our hesitation about the stock, it would be good to know if Parsley Energy insiders have sold any shares recently. You click here to find out if insiders have sold 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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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.