Is BP (LON:BP.) Using Debt Sensibly?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, BP p.l.c. (LON:BP.) does carry 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for BP

What Is BP's Net Debt?

As you can see below, BP had US$63.2b of debt at September 2021, down from US$72.8b a year prior. However, it does have US$30.9b in cash offsetting this, leading to net debt of about US$32.3b.

How Healthy Is BP's Balance Sheet?

According to the last reported balance sheet, BP had liabilities of US$78.1b due within 12 months, and liabilities of US$119.2b due beyond 12 months. Offsetting this, it had US$30.9b in cash and US$26.3b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$140.1b.

This deficit casts a shadow over the US$87.2b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, BP would probably need a major re-capitalization if its creditors were to demand repayment. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Over 12 months, BP reported revenue of US$208b, which is a gain of 40%, although it did not report any earnings before interest and tax. With any luck the company will be able to grow its way to profitability.

Caveat Emptor

Despite the top line growth, BP still had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost US$6.0b at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. But on the bright side the company actually produced a statutory profit of US$6.6b and free cash flow of US$8.7b. So there is definitely a chance that it can improve things in the next few years. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that BP is showing 2 warning signs in our investment analysis , you should know about...

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.

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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.