Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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 Oil Search Limited (ASX:OSH) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Oil Search’s Net Debt?
As you can see below, Oil Search had US$3.40b of debt at June 2019, down from US$3.59b a year prior. However, because it has a cash reserve of US$538.3m, its net debt is less, at about US$2.86b.
How Healthy Is Oil Search’s Balance Sheet?
According to the last reported balance sheet, Oil Search had liabilities of US$1.15b due within 12 months, and liabilities of US$5.07b due beyond 12 months. Offsetting this, it had US$538.3m in cash and US$198.1m in receivables that were due within 12 months. So its liabilities total US$5.48b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$7.33b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Oil Search’s net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 3.9 times last year. While that doesn’t worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, Oil Search grew its EBIT by 46% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Oil Search’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 company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Oil Search recorded free cash flow worth 57% 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.
On our analysis Oil Search’s EBIT growth rate should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Oil Search’s debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. We’d be motivated to research the stock further if we found out that Oil Search insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at email@example.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.