We Think Hemisphere Energy (CVE:HME) Can Stay On Top Of Its Debt

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.' 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. We note that Hemisphere Energy Corporation (CVE:HME) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Hemisphere Energy

How Much Debt Does Hemisphere Energy Carry?

The image below, which you can click on for greater detail, shows that Hemisphere Energy had debt of CA$16.2m at the end of September 2021, a reduction from CA$28.5m over a year. Net debt is about the same, since the it doesn't have much cash.

A Look At Hemisphere Energy's Liabilities

According to the last reported balance sheet, Hemisphere Energy had liabilities of CA$14.2m due within 12 months, and liabilities of CA$25.0m due beyond 12 months. Offsetting this, it had CA$43.8k in cash and CA$3.02m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$36.1m.

Hemisphere Energy has a market capitalization of CA$107.7m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hemisphere Energy has a very low debt to EBITDA ratio of 1.3 so it is strange to see weak interest coverage, with last year's EBIT being only 2.4 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Notably, Hemisphere Energy's EBIT launched higher than Elon Musk, gaining a whopping 116% on last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hemisphere 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Hemisphere Energy produced sturdy free cash flow equating to 73% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Hemisphere Energy's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its interest cover. When we consider the range of factors above, it looks like Hemisphere Energy is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 5 warning signs for Hemisphere Energy (1 shouldn't be ignored!) that you should be aware of before investing here.

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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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.