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. We can see that Baytex Energy Corp. (TSE:BTE) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Baytex Energy's Debt?
The image below, which you can click on for greater detail, shows that Baytex Energy had debt of CA$1.53b at the end of September 2021, a reduction from CA$1.81b over a year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Baytex Energy's Balance Sheet?
The latest balance sheet data shows that Baytex Energy had liabilities of CA$405.2m due within a year, and liabilities of CA$2.40b falling due after that. Offsetting these obligations, it had cash of CA$1.38m as well as receivables valued at CA$177.5m due within 12 months. So its liabilities total CA$2.62b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of CA$2.73b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Baytex Energy has a low net debt to EBITDA ratio of only 0.35. And its EBIT covers its interest expense a whopping 15.2 times over. So we're pretty relaxed about its super-conservative use of debt. Although Baytex Energy made a loss at the EBIT level, last year, it was also good to see that it generated CA$1.5b in EBIT over the last twelve months. 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're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Baytex Energy reported free cash flow worth 13% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Even if we have reservations about how easily Baytex Energy is capable of staying on top of its total liabilities, its interest cover and net debt to EBITDA make us think feel relatively unconcerned. When we consider all the factors discussed, it seems to us that Baytex Energy is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. To that end, you should learn about the 3 warning signs we've spotted with Baytex Energy (including 1 which doesn't sit too well with us) .
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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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.