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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘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. We note that Suncor Energy Inc. (TSE:SU) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Suncor Energy’s Net Debt?
The image below, which you can click on for greater detail, shows that Suncor Energy had debt of CA$16.1b at the end of March 2019, a reduction from CA$17.7b over a year. However, it does have CA$1.88b in cash offsetting this, leading to net debt of about CA$14.3b.
How Strong Is Suncor Energy’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Suncor Energy had liabilities of CA$11.3b due within 12 months and liabilities of CA$37.6b due beyond that. Offsetting these obligations, it had cash of CA$1.88b as well as receivables valued at CA$4.36b due within 12 months. So it has liabilities totalling CA$42.7b more than its cash and near-term receivables, combined.
This is a mountain of leverage even relative to its gargantuan market capitalization of CA$65.9b. So should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Either way, since Suncor Energy does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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.
With net debt sitting at just 1.14 times EBITDA, Suncor Energy is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.19 times the interest expense over the last year. In addition to that, we’re happy to report that Suncor Energy has boosted its EBIT by 40%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Suncor 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Suncor Energy recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Suncor Energy’s demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Suncor Energy can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. We’d be motivated to research the stock further if we found out that Suncor Energy insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.