Here's Why MEG Energy (TSE:MEG) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies MEG Energy Corp. (TSE:MEG) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

See our latest analysis for MEG Energy

How Much Debt Does MEG Energy Carry?

You can click the graphic below for the historical numbers, but it shows that MEG Energy had CA$1.47b of debt in March 2023, down from CA$2.44b, one year before. However, it also had CA$103.0m in cash, and so its net debt is CA$1.36b.

How Healthy Is MEG Energy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that MEG Energy had liabilities of CA$645.0m due within 12 months and liabilities of CA$1.92b due beyond that. Offsetting these obligations, it had cash of CA$103.0m as well as receivables valued at CA$570.0m due within 12 months. So its liabilities total CA$1.89b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since MEG Energy has a market capitalization of CA$5.86b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt sitting at just 0.79 times EBITDA, MEG Energy is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.7 times the interest expense over the last year. The good news is that MEG Energy has increased its EBIT by 8.0% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if MEG 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last two years, MEG Energy generated free cash flow amounting to a very robust 88% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

MEG Energy's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its net debt to EBITDA also supports that impression! When we consider the range of factors above, it looks like MEG Energy is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that MEG Energy insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

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.