Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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. As with many other companies Granite Oil Corp. (TSE:GXO) makes use of debt. But is this debt a concern to shareholders?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Granite Oil Carry?
The chart below, which you can click on for greater detail, shows that Granite Oil had CA$44.3m in debt in June 2019; about the same as the year before. And it doesn’t have much cash, so its net debt is about the same.
A Look At Granite Oil’s Liabilities
Zooming in on the latest balance sheet data, we can see that Granite Oil had liabilities of CA$47.9m due within 12 months and liabilities of CA$31.0m due beyond that. Offsetting this, it had CA$690.0k in cash and CA$4.42m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$73.8m.
This deficit casts a shadow over the CA$23.6m company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt After all, Granite Oil would likely require a major re-capitalisation if it had to pay its creditors today.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Granite Oil has net debt worth 2.1 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 2.7 times the interest expense. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. Notably, Granite Oil made a loss at the EBIT level, last year, but improved that to positive EBIT of CA$6.6m in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Granite Oil 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Granite Oil produced sturdy free cash flow equating to 54% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Mulling over Granite Oil’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Overall, it seems to us that Granite Oil’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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