Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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, Eland Oil & Gas PLC (LON:ELA) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Eland Oil & Gas’s Debt?
The image below, which you can click on for greater detail, shows that at December 2018 Eland Oil & Gas had debt of US$47.4m, up from US$25.4m in one year. On the flip side, it has US$43.1m in cash leading to net debt of about US$4.26m.
How Healthy Is Eland Oil & Gas’s Balance Sheet?
We can see from the most recent balance sheet that Eland Oil & Gas had liabilities of US$100.9m falling due within a year, and liabilities of US$58.2m due beyond that. On the other hand, it had cash of US$43.1m and US$68.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$47.3m.
Of course, Eland Oil & Gas has a market capitalization of US$325.0m, so these liabilities are probably manageable. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. But either way, Eland Oil & Gas has virtually no net debt, so it’s fair to say it does not have a heavy debt load!
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).
Eland Oil & Gas has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.04 and EBIT of 17.6 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. It was also good to see that despite losing money on the EBIT line last year, Eland Oil & Gas turned things around in the last 12 months, delivering and EBIT of US$79m. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Eland Oil & Gas’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Eland Oil & Gas saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Eland Oil & Gas’s conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about Eland Oil & Gas’s debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. We’d be motivated to research the stock further if we found out that Eland Oil & Gas insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.