Is Obsidian Energy (TSE:OBE) 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. As with many other companies Obsidian Energy Ltd. (TSE:OBE) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Obsidian Energy

What Is Obsidian Energy's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Obsidian Energy had CA$342.1m of debt, an increase on CA$230.7m, over one year. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Obsidian Energy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Obsidian Energy had liabilities of CA$249.7m due within 12 months and liabilities of CA$447.4m due beyond that. On the other hand, it had cash of CA$900.0k and CA$87.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$608.4m.

Given this deficit is actually higher than the company's market capitalization of CA$578.1m, we think shareholders really should watch Obsidian 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Obsidian Energy's low debt to EBITDA ratio of 0.77 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.7 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly, Obsidian Energy's EBIT fell a jaw-dropping 63% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Obsidian Energy can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Obsidian Energy reported free cash flow worth 9.1% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We'd go so far as to say Obsidian Energy's EBIT growth rate was disappointing. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Overall, it seems to us that Obsidian Energy's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Obsidian Energy you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.