Petrus Resources (TSE:PRQ) Has A Pretty Healthy Balance Sheet

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 Petrus Resources Ltd. (TSE:PRQ) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Petrus Resources

How Much Debt Does Petrus Resources Carry?

The image below, which you can click on for greater detail, shows that Petrus Resources had debt of CA$29.6m at the end of December 2022, a reduction from CA$57.7m over a year. However, it does have CA$1.90m in cash offsetting this, leading to net debt of about CA$27.7m.

How Healthy Is Petrus Resources' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Petrus Resources had liabilities of CA$51.4m due within 12 months and liabilities of CA$63.0m due beyond that. On the other hand, it had cash of CA$1.90m and CA$22.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$90.3m.

While this might seem like a lot, it is not so bad since Petrus Resources has a market capitalization of CA$185.6m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Petrus Resources's net debt is only 0.28 times its EBITDA. And its EBIT easily covers its interest expense, being 24.5 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Petrus Resources grew its EBIT by 86% over the last twelve months, and that growth will make it easier to handle its debt. 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 Petrus Resources'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. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, Petrus Resources reported free cash flow worth 9.9% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Happily, Petrus Resources's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Petrus Resources can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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 3 warning signs with Petrus Resources (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.