Is Tethys Petroleum (CVE:TPL) Using Too Much Debt?

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 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. As with many other companies Tethys Petroleum Limited (CVE:TPL) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Tethys Petroleum

How Much Debt Does Tethys Petroleum Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Tethys Petroleum had US$6.87m of debt, an increase on US$5.79m, over one year. But on the other hand it also has US$11.7m in cash, leading to a US$4.78m net cash position.

A Look At Tethys Petroleum's Liabilities

We can see from the most recent balance sheet that Tethys Petroleum had liabilities of US$32.4m falling due within a year, and liabilities of US$15.3m due beyond that. On the other hand, it had cash of US$11.7m and US$4.85m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$31.2m.

Tethys Petroleum has a market capitalization of US$66.7m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Tethys Petroleum also has more cash than debt, so we're pretty confident it can manage its debt safely.

Although Tethys Petroleum made a loss at the EBIT level, last year, it was also good to see that it generated US$13m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Tethys Petroleum's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Tethys Petroleum has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last year, Tethys Petroleum recorded free cash flow worth a fulsome 98% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

Although Tethys Petroleum's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$4.78m. And it impressed us with free cash flow of US$13m, being 98% of its EBIT. So we don't have any problem with Tethys Petroleum's use of debt. 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. Case in point: We've spotted 1 warning sign for Tethys Petroleum you should be aware of.

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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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.