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 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 can see that Enerplus Corporation (TSE:ERF) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. 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. 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 step when considering a company’s debt levels is to consider its cash and debt together.
What Is Enerplus’s Debt?
You can click the graphic below for the historical numbers, but it shows that Enerplus had CA$611.5m of debt in June 2019, down from CA$672.2m, one year before. However, it also had CA$252.5m in cash, and so its net debt is CA$359.0m.
How Healthy Is Enerplus’s Balance Sheet?
The latest balance sheet data shows that Enerplus had liabilities of CA$475.2m due within a year, and liabilities of CA$675.9m falling due after that. On the other hand, it had cash of CA$252.5m and CA$160.0m worth of receivables due within a year. So its liabilities total CA$738.5m more than the combination of its cash and short-term receivables.
Enerplus has a market capitalization of CA$1.99b, 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 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). 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).
Enerplus’s net debt is only 0.40 times its EBITDA. And its EBIT easily covers its interest expense, being 15.8 times the size. So we’re pretty relaxed about its super-conservative use of debt. Better yet, Enerplus grew its EBIT by 301% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Enerplus reported free cash flow worth 7.8% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Enerplus’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Enerplus can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. We’d be motivated to research the stock further if we found out that Enerplus insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
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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