David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Canacol Energy Ltd (TSE:CNE) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
View our latest analysis for Canacol Energy
What Is Canacol Energy's Debt?
As you can see below, at the end of September 2019, Canacol Energy had US$341.1m of debt, up from US$311 a year ago. Click the image for more detail. However, because it has a cash reserve of US$34.6m, its net debt is less, at about US$306.5m.
A Look At Canacol Energy's Liabilities
We can see from the most recent balance sheet that Canacol Energy had liabilities of US$77.4m falling due within a year, and liabilities of US$435.5m due beyond that. On the other hand, it had cash of US$34.6m and US$77.7m worth of receivables due within a year. So it has liabilities totalling US$400.5m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$646.9m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Canacol Energy's net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 3.1 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. Notably, Canacol Energy's EBIT launched higher than Elon Musk, gaining a whopping 157% on last year. 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 Canacol 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Canacol Energy saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
Neither Canacol Energy's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Canacol Energy's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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, we've discovered 1 warning sign for Canacol Energy which any shareholder or potential investor 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.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.
About TSX:CNE
Undervalued slight.
