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 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. Importantly, ConocoPhillips (NYSE:COP) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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 examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does ConocoPhillips Carry?
The image below, which you can click on for greater detail, shows that ConocoPhillips had debt of US$14.2b at the end of June 2019, a reduction from US$15.0b over a year. On the flip side, it has US$8.51b in cash leading to net debt of about US$5.67b.
How Healthy Is ConocoPhillips’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that ConocoPhillips had liabilities of US$9.00b due within 12 months and liabilities of US$29.2b due beyond that. On the other hand, it had cash of US$8.51b and US$3.65b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$26.0b.
ConocoPhillips has a very large market capitalization of US$58.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
ConocoPhillips has a low net debt to EBITDA ratio of only 0.36. And its EBIT covers its interest expense a whopping 13.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we’re happy to report that ConocoPhillips has boosted its EBIT by 45%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. 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, 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 most recent two years, ConocoPhillips recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
ConocoPhillips’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But, on a more sombre note, we are a little concerned by its level of total liabilities. Taking all this data into account, it seems to us that ConocoPhillips takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Over time, share prices tend to follow earnings per share, so if you’re interested in ConocoPhillips, you may well want to click here to check an interactive graph of its earnings per share history.
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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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. Thank you for reading.