Here's Why Canacol Energy (TSE:CNE) Has A Meaningful Debt Burden

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.' 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. We note that Canacol Energy Ltd (TSE:CNE) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Canacol Energy

What Is Canacol Energy's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 Canacol Energy had US$495.3m of debt, an increase on US$381.6m, over one year. However, it also had US$92.6m in cash, and so its net debt is US$402.7m.

How Strong Is Canacol Energy's Balance Sheet?

According to the last reported balance sheet, Canacol Energy had liabilities of US$126.0m due within 12 months, and liabilities of US$585.4m due beyond 12 months. Offsetting these obligations, it had cash of US$92.6m as well as receivables valued at US$76.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$542.0m.

This deficit casts a shadow over the US$219.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Canacol Energy would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Canacol Energy's net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 3.2 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We note that Canacol Energy grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. 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 Canacol Energy can strengthen its balance sheet over time. 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 we always check how much of that EBIT is translated into free cash flow. In the last three years, Canacol Energy's free cash flow amounted to 39% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say Canacol Energy's level of total liabilities was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Canacol Energy has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Canacol Energy (of which 1 makes us a bit uncomfortable!) you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.