Is Otto Energy (ASX:OEL) Using Too Much Debt?

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 Otto Energy Limited (ASX:OEL) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 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. 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.

Our analysis indicates that OEL is potentially undervalued!

What Is Otto Energy's Debt?

As you can see below, Otto Energy had US$1.95m of debt at June 2022, down from US$10.1m a year prior. But on the other hand it also has US$25.3m in cash, leading to a US$23.4m net cash position.

How Healthy Is Otto Energy's Balance Sheet?

According to the last reported balance sheet, Otto Energy had liabilities of US$13.0m due within 12 months, and liabilities of US$3.75m due beyond 12 months. On the other hand, it had cash of US$25.3m and US$5.19m worth of receivables due within a year. So it actually has US$13.8m more liquid assets than total liabilities.

This surplus suggests that Otto Energy is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Otto Energy has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Otto Energy grew its EBIT by 11,085% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Otto Energy will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Otto Energy may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent two years, Otto Energy recorded free cash flow worth 80% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Otto Energy has net cash of US$23.4m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 11,085% over the last year. The bottom line is that we do not find Otto Energy's debt levels at all concerning. 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. For example - Otto Energy has 2 warning signs we think you should be aware of.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.