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.' 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. As with many other companies Woodside Petroleum Ltd (ASX:WPL) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.
What Is Woodside Petroleum's Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Woodside Petroleum had debt of US$6.21b, up from US$5.68b in one year. On the flip side, it has US$3.78b in cash leading to net debt of about US$2.44b.
A Look At Woodside Petroleum's Liabilities
Zooming in on the latest balance sheet data, we can see that Woodside Petroleum had liabilities of US$2.09b due within 12 months and liabilities of US$9.65b due beyond that. Offsetting these obligations, it had cash of US$3.78b as well as receivables valued at US$303.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.67b.
Woodside Petroleum has a very large market capitalization of US$18.0b, so it could very likely raise cash to 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.
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). 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).
Given net debt is only 1.4 times EBITDA, it is initially surprising to see that Woodside Petroleum's EBIT has low interest coverage of 0.17 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Importantly, Woodside Petroleum's EBIT fell a jaw-dropping 98% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Woodside Petroleum can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Woodside Petroleum generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Woodside Petroleum's EBIT growth rate and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Woodside Petroleum's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 2 warning signs with Woodside Petroleum (at least 1 which can't be ignored) , and understanding them should be part of your investment process.
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.
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Woodside Energy Group
Woodside Energy Group Ltd engages in the exploration, evaluation, development, production, marketing, and sale of hydrocarbons in Oceania, Asia, Canada, Africa, and internationally.
Excellent balance sheet with proven track record and pays a dividend.