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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies. TORC Oil & Gas Ltd. (TSE:TOG) makes use of debt. But the real question is whether this debt is making the company risky.
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. If things get really bad, the lenders can take control of the business. 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 step when considering a company’s debt levels is to consider its cash and debt together.
View our latest analysis for TORC Oil & Gas
What Is TORC Oil & Gas’s Debt?
As you can see below, at the end of March 2019, TORC Oil & Gas had CA$355.0m of debt, up from CA$233.1m a year ago. Click the image for more detail. And it doesn’t have much cash, so its net debt is about the same.
How Strong Is TORC Oil & Gas’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that TORC Oil & Gas had liabilities of CA$102.1m due within 12 months and liabilities of CA$772.8m due beyond that. Offsetting this, it had CA$6.47m in cash and CA$54.5m in receivables that were due within 12 months. So its liabilities total CA$813.9m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of CA$887.6m. So should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Because it carries more debt than cash, we think it’s worth watching TORC Oil & Gas’s balance sheet over time.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Looking at its net debt to EBITDA of 1.14 and interest cover of 4.88 times, it seems to us that TORC Oil & Gas is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, TORC Oil & Gas’s EBIT launched higher than Elon Musk, gaining a whopping 200% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if TORC Oil & Gas 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 we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, TORC Oil & Gas actually produced more free cash flow than EBIT over the last two years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
Our View
Happily, TORC Oil & Gas’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. 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 TORC Oil & Gas 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. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that TORC Oil & Gas insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.