Here's Why BP (LON:BP.) Can Manage Its Debt Responsibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that BP p.l.c. (LON:BP.) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for BP

What Is BP's Net Debt?

You can click the graphic below for the historical numbers, but it shows that BP had US$49.7b of debt in June 2023, down from US$52.9b, one year before. However, it also had US$29.6b in cash, and so its net debt is US$20.2b.

How Strong Is BP's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that BP had liabilities of US$81.5b due within 12 months and liabilities of US$109.0b due beyond that. Offsetting this, it had US$29.6b in cash and US$28.7b in receivables that were due within 12 months. So it has liabilities totalling US$132.2b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's massive market capitalization of US$109.2b, we think shareholders really should watch BP's debt levels, like a parent watching their child ride a bike for the first time. 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

BP has a low net debt to EBITDA ratio of only 0.39. And its EBIT covers its interest expense a whopping 23.6 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that BP has boosted its EBIT by 48%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine BP's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last two years, BP produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, BP's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its level of total liabilities. Looking at all the aforementioned factors together, it strikes us that BP can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for BP you should be aware of, and 1 of them is concerning.

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.