Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Enerplus Corporation (TSE:ERF) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Enerplus Carry?
The image below, which you can click on for greater detail, shows that Enerplus had debt of CA$513.3m at the end of September 2020, a reduction from CA$618.4m over a year. However, because it has a cash reserve of CA$84.5m, its net debt is less, at about CA$428.8m.
How Healthy Is Enerplus' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Enerplus had liabilities of CA$373.2m due within 12 months and liabilities of CA$578.7m due beyond that. Offsetting this, it had CA$84.5m in cash and CA$107.0m in receivables that were due within 12 months. So it has liabilities totalling CA$760.3m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of CA$1.08b, so it does suggest shareholders should keep an eye on Enerplus' use of debt. 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.
While Enerplus's low debt to EBITDA ratio of 1.0 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.8 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, Enerplus's EBIT fell a jaw-dropping 84% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Enerplus 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Enerplus recorded free cash flow of 28% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
We'd go so far as to say Enerplus's EBIT growth rate was disappointing. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Enerplus has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Enerplus that you should be aware of before investing here.
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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