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 Vermilion Energy Inc. (TSE:VET) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Vermilion Energy Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Vermilion Energy had CA$1.85b of debt, an increase on CA$1.38b, over one year. Net debt is about the same, since the it doesn’t have much cash.
How Strong Is Vermilion Energy’s Balance Sheet?
According to the last reported balance sheet, Vermilion Energy had liabilities of CA$459.2m due within 12 months, and liabilities of CA$3.03b due beyond 12 months. Offsetting these obligations, it had cash of CA$5.22m as well as receivables valued at CA$253.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$3.23b.
This is a mountain of leverage relative to its market capitalization of CA$3.76b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Vermilion Energy’s net debt is sitting at a very reasonable 1.7 times its EBITDA, while its EBIT covered its interest expense just 4.9 times last year. In large part that’s due to the company’s significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. Notably, Vermilion Energy’s EBIT launched higher than Elon Musk, gaining a whopping 618% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Vermilion 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 we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Vermilion Energy 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.
Vermilion Energy’s conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But, on a more sombre note, we are a little concerned by its level of total liabilities. All these things considered, it appears that Vermilion Energy can comfortably handle its current debt levels. 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. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Vermilion Energy insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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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