Tethys Petroleum (CVE:TPL) Seems To Use Debt Quite Sensibly

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.' 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 can see that Tethys Petroleum Limited (CVE:TPL) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Tethys Petroleum

What Is Tethys Petroleum's Debt?

The image below, which you can click on for greater detail, shows that Tethys Petroleum had debt of US$4.71m at the end of September 2022, a reduction from US$6.30m over a year. But it also has US$15.0m in cash to offset that, meaning it has US$10.3m net cash.

How Healthy Is Tethys Petroleum's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tethys Petroleum had liabilities of US$26.1m due within 12 months and liabilities of US$14.6m due beyond that. On the other hand, it had cash of US$15.0m and US$7.20m worth of receivables due within a year. So it has liabilities totalling US$18.5m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Tethys Petroleum is worth US$62.6m, and thus could probably raise enough capital to shore up 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$36m in EBIT over 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 Tethys Petroleum will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 most recent year, Tethys Petroleum recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While Tethys Petroleum does have more liabilities than liquid assets, it also has net cash of US$10.3m. So we are not troubled with Tethys Petroleum's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - Tethys Petroleum has 3 warning signs we think you should be aware of.

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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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.