David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. 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. As with many other companies Peyto Exploration & Development Corp. (TSE:PEY) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Peyto Exploration & Development’s Net Debt?
The chart below, which you can click on for greater detail, shows that Peyto Exploration & Development had CA$1.13b in debt in September 2019; about the same as the year before. And it doesn’t have much cash, so its net debt is about the same.
How Strong Is Peyto Exploration & Development’s Balance Sheet?
We can see from the most recent balance sheet that Peyto Exploration & Development had liabilities of CA$72.3m falling due within a year, and liabilities of CA$1.79b due beyond that. Offsetting these obligations, it had cash of CA$592.0k as well as receivables valued at CA$50.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$1.82b.
The deficiency here weighs heavily on the CA$456.7m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Peyto Exploration & Development would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Peyto Exploration & Development has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 2.7 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Even worse, Peyto Exploration & Development saw its EBIT tank 48% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that 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 Peyto Exploration & Development’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 always check how much of that EBIT is translated into free cash flow. During the last three years, Peyto Exploration & Development produced sturdy free cash flow equating to 52% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
On the face of it, Peyto Exploration & Development’s EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Taking into account all the aforementioned factors, it looks like Peyto Exploration & Development has too much debt. While some investors love that sort of risky play, it’s certainly not our cup of tea. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Consider for instance, the ever-present spectre of investment risk. We’ve identified 4 warning signs with Peyto Exploration & Development (at least 2 which are a bit concerning) , and understanding them should be part of your investment process.
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.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.