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.' 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. We can see that Baytex Energy Corp. (TSE:BTE) does use debt in its business. But is this debt a concern to shareholders?
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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Baytex Energy's Net Debt?
As you can see below, Baytex Energy had CA$1.09b of debt at September 2022, down from CA$1.53b a year prior. And it doesn't have much cash, so its net debt is about the same.
How Healthy Is Baytex Energy's Balance Sheet?
According to the last reported balance sheet, Baytex Energy had liabilities of CA$331.6m due within 12 months, and liabilities of CA$1.87b due beyond 12 months. Offsetting this, it had CA$4.41m in cash and CA$251.7m in receivables that were due within 12 months. So it has liabilities totalling CA$1.94b more than its cash and near-term receivables, combined.
Baytex Energy has a market capitalization of CA$3.57b, 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.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Baytex Energy's net debt is only 0.60 times its EBITDA. And its EBIT covers its interest expense a whopping 13.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Baytex Energy grew its EBIT by 3.4% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Baytex Energy's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last two years, Baytex Energy's free cash flow amounted to 35% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On our analysis Baytex Energy's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about Baytex Energy's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Baytex Energy is showing 3 warning signs in our investment analysis , and 1 of those is potentially serious...
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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