Stock Analysis

Woodside Petroleum (ASX:WPL) Takes On Some Risk With Its Use Of Debt

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ASX:WDS
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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Woodside Petroleum Ltd (ASX:WPL) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 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.

Check out our latest analysis for Woodside Petroleum

How Much Debt Does Woodside Petroleum Carry?

The image below, which you can click on for greater detail, shows that Woodside Petroleum had debt of US$5.47b at the end of June 2021, a reduction from US$6.24b over a year. On the flip side, it has US$3.06b in cash leading to net debt of about US$2.41b.

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ASX:WPL Debt to Equity History August 26th 2021

How Healthy Is Woodside Petroleum's Balance Sheet?

The latest balance sheet data shows that Woodside Petroleum had liabilities of US$1.39b due within a year, and liabilities of US$9.43b falling due after that. Offsetting these obligations, it had cash of US$3.06b as well as receivables valued at US$353.0m due within 12 months. So it has liabilities totalling US$7.41b more than its cash and near-term receivables, combined.

Woodside Petroleum has a very large market capitalization of US$14.2b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Looking at its net debt to EBITDA of 1.0 and interest cover of 3.2 times, it seems to us that Woodside Petroleum is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Shareholders should be aware that Woodside Petroleum's EBIT was down 34% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. 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.

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. Happily for any shareholders, Woodside Petroleum actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

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. Looking at all the angles mentioned above, it does seem to us that Woodside Petroleum 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Woodside Petroleum that you should be aware of.

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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