Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that International Petroleum Corporation (TSE:IPCO) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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, 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.
What Is International Petroleum's Debt?
As you can see below, at the end of September 2020, International Petroleum had US$328.4m of debt, up from US$219.0m a year ago. Click the image for more detail. On the flip side, it has US$10.2m in cash leading to net debt of about US$318.1m.
A Look At International Petroleum's Liabilities
Zooming in on the latest balance sheet data, we can see that International Petroleum had liabilities of US$110.0m due within 12 months and liabilities of US$537.2m due beyond that. Offsetting these obligations, it had cash of US$10.2m as well as receivables valued at US$50.6m due within 12 months. So it has liabilities totalling US$586.4m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's US$418.3m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. 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 International Petroleum'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.
In the last year International Petroleum had a loss before interest and tax, and actually shrunk its revenue by 30%, to US$358m. To be frank that doesn't bode well.
Not only did International Petroleum's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). To be specific the EBIT loss came in at US$3.4m. When we look at that alongside the significant liabilities, we're not particularly confident about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it had negative free cash flow of US$16m over the last twelve months. That means it's on the risky side of things. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for International Petroleum that you should be aware of before investing here.
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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