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.’ 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. We note that Husky Energy Inc. (TSE:HSE) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
How Much Debt Does Husky Energy Carry?
As you can see below, Husky Energy had CA$6.18b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have CA$2.51b in cash offsetting this, leading to net debt of about CA$3.67b.
How Strong Is Husky Energy’s Balance Sheet?
We can see from the most recent balance sheet that Husky Energy had liabilities of CA$4.86b falling due within a year, and liabilities of CA$11.6b due beyond that. Offsetting this, it had CA$2.51b in cash and CA$1.43b in receivables that were due within 12 months. So its liabilities total CA$12.5b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company’s market capitalization of CA$8.68b, we think shareholders really should watch Husky Energy’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Looking at its net debt to EBITDA of 0.96 and interest cover of 7.0 times, it seems to us that Husky Energy is probably using debt in a pretty reasonable way. So we’d recommend keeping a close eye on the impact financing costs are having on the business. It is just as well that Husky Energy’s load is not too heavy, because its EBIT was down 23% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Husky Energy can strengthen its balance sheet over time. 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. Looking at the most recent two years, Husky Energy recorded free cash flow of 35% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
To be frank both Husky Energy’s level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it’s pretty decent at covering its interest expense with its EBIT; that’s encouraging. We’re quite clear that we consider Husky Energy to be really rather risky, as a result of its balance sheet health. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Given our concerns about Husky Energy’s debt levels, it seems only prudent to check if insiders have been ditching the stock.
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.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.