Perpetual Energy (TSE:PMT) Seems To Be Using A Lot Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Perpetual Energy Inc. (TSE:PMT) makes use of debt. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Perpetual Energy

What Is Perpetual Energy's Net Debt?

The image below, which you can click on for greater detail, shows that Perpetual Energy had debt of CA$45.6m at the end of September 2022, a reduction from CA$96.3m over a year. On the flip side, it has CA$2.75m in cash leading to net debt of about CA$42.8m.

How Strong Is Perpetual Energy's Balance Sheet?

We can see from the most recent balance sheet that Perpetual Energy had liabilities of CA$41.1m falling due within a year, and liabilities of CA$72.1m due beyond that. Offsetting this, it had CA$2.75m in cash and CA$13.8m in receivables that were due within 12 months. So it has liabilities totalling CA$96.7m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the CA$48.3m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Perpetual Energy would likely require a major re-capitalisation if it had to pay its creditors today.

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 Perpetual Energy's low debt to EBITDA ratio of 0.96 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.9 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Although Perpetual Energy made a loss at the EBIT level, last year, it was also good to see that it generated CA$36m 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 Perpetual Energy's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Perpetual Energy saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Perpetual Energy's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. We're quite clear that we consider Perpetual Energy to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 5 warning signs with Perpetual Energy (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.