GP Petroleums (NSE:GULFPETRO) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that GP Petroleums Limited (NSE:GULFPETRO) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for GP Petroleums

What Is GP Petroleums's Debt?

The image below, which you can click on for greater detail, shows that GP Petroleums had debt of ₹338.9m at the end of March 2020, a reduction from ₹1.35b over a year. On the flip side, it has ₹27.2m in cash leading to net debt of about ₹311.7m.

How Strong Is GP Petroleums's Balance Sheet?

According to the last reported balance sheet, GP Petroleums had liabilities of ₹682.3m due within 12 months, and liabilities of ₹91.3m due beyond 12 months. Offsetting this, it had ₹27.2m in cash and ₹797.5m in receivables that were due within 12 months. So it actually has ₹51.1m more liquid assets than total liabilities.

This surplus suggests that GP Petroleums has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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.

While GP Petroleums has a quite reasonable net debt to EBITDA multiple of 1.7, its interest cover seems weak, at 2.5. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Importantly, GP Petroleums's EBIT fell a jaw-dropping 51% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since GP Petroleums will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, GP Petroleums actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

GP Petroleums's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about GP Petroleums'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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that GP Petroleums is showing 2 warning signs in our investment analysis , you should know about...

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.

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