Is Imperial Oil (TSE:IMO) A Risky Investment?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Imperial Oil Limited (TSE:IMO) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

Check out our latest analysis for Imperial Oil

What Is Imperial Oil's Net Debt?

The chart below, which you can click on for greater detail, shows that Imperial Oil had CA$4.57b in debt in March 2022; about the same as the year before. On the flip side, it has CA$3.15b in cash leading to net debt of about CA$1.42b.

A Look At Imperial Oil's Liabilities

Zooming in on the latest balance sheet data, we can see that Imperial Oil had liabilities of CA$8.65b due within 12 months and liabilities of CA$12.9b due beyond that. Offsetting this, it had CA$3.15b in cash and CA$5.41b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$13.0b.

While this might seem like a lot, it is not so bad since Imperial Oil has a huge market capitalization of CA$36.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Imperial Oil has a low net debt to EBITDA ratio of only 0.23. And its EBIT covers its interest expense a whopping 531 times over. So we're pretty relaxed about its super-conservative use of debt. Although Imperial Oil made a loss at the EBIT level, last year, it was also good to see that it generated CA$4.2b in EBIT over the last twelve months. 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 Imperial Oil'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Imperial Oil actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Happily, Imperial Oil's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! When we consider the range of factors above, it looks like Imperial Oil is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. Be aware that Imperial Oil is showing 3 warning signs in our investment analysis , and 1 of those is significant...

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.