Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Goodrich Petroleum Corporation (NYSEMKT:GDP) does use debt in its business. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Goodrich Petroleum Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 Goodrich Petroleum had US$107.7m of debt, an increase on US$94.9m, over one year. Net debt is about the same, since the it doesn’t have much cash.
How Healthy Is Goodrich Petroleum’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Goodrich Petroleum had liabilities of US$36.5m due within 12 months and liabilities of US$116.5m due beyond that. Offsetting these obligations, it had cash of US$1.56m as well as receivables valued at US$9.21m due within 12 months. So its liabilities total US$142.2m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company’s US$96.9m 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.
While Goodrich Petroleum has a quite reasonable net debt to EBITDA multiple of 1.9, its interest cover seems weak, at 0.37. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason — some assets are seen to be losing value. In any case, it’s safe to say the company has meaningful debt. Importantly, Goodrich Petroleum’s EBIT fell a jaw-dropping 93% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Goodrich Petroleum’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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, Goodrich Petroleum saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Goodrich Petroleum’s conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its net debt to EBITDA is not so bad. Considering all the factors previously mentioned, we think that Goodrich Petroleum really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example – Goodrich Petroleum has 2 warning signs we think you should be aware of.
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.
When trading Goodrich Petroleum or any other investment, use the platform considered by many to be the Professional’s Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email email@example.com.