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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.’ 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 note that Parsley Energy, Inc. (NYSE:PE) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Parsley Energy’s Debt?
As you can see below, Parsley Energy had US$2.18b of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn’t have much cash.
How Healthy Is Parsley Energy’s Balance Sheet?
According to the last reported balance sheet, Parsley Energy had liabilities of US$741.4m due within 12 months, and liabilities of US$2.52b due beyond 12 months. Offsetting these obligations, it had cash of US$10.4m as well as receivables valued at US$215.2m due within 12 months. So it has liabilities totalling US$3.04b more than its cash and near-term receivables, combined.
Parsley Energy has a market capitalization of US$5.81b, so it could very likely ameliorate its balance sheet if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Since Parsley Energy does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Parsley Energy has net debt worth 1.63 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 4.02 times the interest expense. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. Importantly, Parsley Energy grew its EBIT by 91% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Parsley Energy’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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Parsley Energy saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Parsley Energy’s conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Parsley Energy is a somewhat risky investment as a result of its debt. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Given our hesitation about the stock, it would be good to know if Parsley Energy insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.