We Think Energy One (ASX:EOL) Can Stay On Top Of Its Debt

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Energy One Limited (ASX:EOL) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Energy One

What Is Energy One's Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Energy One had debt of AU$21.7m, up from AU$2.84m in one year. However, because it has a cash reserve of AU$2.14m, its net debt is less, at about AU$19.6m.

How Healthy Is Energy One's Balance Sheet?

According to the last reported balance sheet, Energy One had liabilities of AU$15.3m due within 12 months, and liabilities of AU$28.6m due beyond 12 months. On the other hand, it had cash of AU$2.14m and AU$6.48m worth of receivables due within a year. So it has liabilities totalling AU$35.2m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Energy One is worth AU$95.8m, and thus could probably raise enough capital to shore up 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Energy One has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 5.6 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Energy One grew its EBIT by 7.6% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Energy One's earnings that will influence how the balance sheet holds up in the future. 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Energy One produced sturdy free cash flow equating to 54% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We weren't impressed with Energy One's level of total liabilities, and its net debt to EBITDA made us cautious. Balancing that a bit, it has a demonstrated ability conversion of EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Energy One's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Energy One has 3 warning signs we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.