We Think Imperial Oil (TSE:IMO) Can Manage Its Debt With Ease

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.' 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. We can see that Imperial Oil Limited (TSE:IMO) does use debt in its business. But is this debt a concern to shareholders?

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. 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out the opportunities and risks within the CA Oil and Gas industry.

How Much Debt Does Imperial Oil Carry?

The image below, which you can click on for greater detail, shows that Imperial Oil had debt of CA$3.57b at the end of September 2022, a reduction from CA$4.57b over a year. However, its balance sheet shows it holds CA$3.58b in cash, so it actually has CA$7.00m net cash.

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$8.93b due within 12 months and liabilities of CA$11.7b due beyond that. Offsetting these obligations, it had cash of CA$3.58b as well as receivables valued at CA$5.18b due within 12 months. So it has liabilities totalling CA$11.9b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Imperial Oil is worth a massive CA$45.7b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Imperial Oil boasts net cash, so it's fair to say it does not have a heavy debt load!

Even more impressive was the fact that Imperial Oil grew its EBIT by 269% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Imperial Oil may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, Imperial Oil actually produced more free cash flow than EBIT over the last two years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing Up

While Imperial Oil does have more liabilities than liquid assets, it also has net cash of CA$7.00m. The cherry on top was that in converted 107% of that EBIT to free cash flow, bringing in CA$7.9b. So we don't think Imperial Oil's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Imperial Oil , and understanding them should be part of your investment process.

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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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.