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.’ 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 can see that Cimarex Energy Co. (NYSE:XEC) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Cimarex Energy Carry?
As you can see below, Cimarex Energy had US$1.99b of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$43.8m, its net debt is less, at about US$1.94b.
How Healthy Is Cimarex Energy’s Balance Sheet?
The latest balance sheet data shows that Cimarex Energy had liabilities of US$504.8m due within a year, and liabilities of US$2.43b falling due after that. Offsetting these obligations, it had cash of US$43.8m as well as receivables valued at US$244.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.65b.
When you consider that this deficiency exceeds the company’s US$2.62b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Cimarex Energy’s net debt to EBITDA ratio of about 1.5 suggests only moderate use of debt. And its strong interest cover of 10.4 times, makes us even more comfortable. The modesty of its debt load may become crucial for Cimarex Energy if management cannot prevent a repeat of the 56% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Cimarex Energy 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Cimarex Energy recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
To be frank both Cimarex Energy’s conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We’re quite clear that we consider Cimarex Energy to be really rather risky, as a result of its balance sheet health. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we’ve spotted 2 warning signs for Cimarex Energy you should know about.
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.
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