Stock Analysis

Here's Why Crown Point Energy (CVE:CWV) Has A Meaningful Debt Burden

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TSXV:CWV
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The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Crown Point Energy Inc. (CVE:CWV) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Crown Point Energy

How Much Debt Does Crown Point Energy Carry?

The image below, which you can click on for greater detail, shows that at September 2021 Crown Point Energy had debt of US$5.45m, up from US$1.67m in one year. However, it also had US$3.31m in cash, and so its net debt is US$2.14m.

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TSXV:CWV Debt to Equity History January 29th 2022

How Healthy Is Crown Point Energy's Balance Sheet?

The latest balance sheet data shows that Crown Point Energy had liabilities of US$4.57m due within a year, and liabilities of US$20.0m falling due after that. Offsetting these obligations, it had cash of US$3.31m as well as receivables valued at US$1.85m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$19.4m.

When you consider that this deficiency exceeds the company's US$14.0m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). 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).

Crown Point Energy has a very low debt to EBITDA ratio of 0.13 so it is strange to see weak interest coverage, with last year's EBIT being only 0.26 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Notably, Crown Point Energy made a loss at the EBIT level, last year, but improved that to positive EBIT of US$190k in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Crown Point Energy will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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 the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Crown Point Energy actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

We feel some trepidation about Crown Point Energy's difficulty interest cover, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and net debt to EBITDA were encouraging signs. When we consider all the factors discussed, it seems to us that Crown Point Energy is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Crown Point Energy (1 makes us a bit uncomfortable) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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