The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Delek Drilling - Limited Partnership (TLV:DEDR.L) makes use of debt. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Delek Drilling - Limited Partnership Carry?
As you can see below, Delek Drilling - Limited Partnership had US$3.25b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$592.7m, its net debt is less, at about US$2.66b.
How Strong Is Delek Drilling - Limited Partnership's Balance Sheet?
According to the last reported balance sheet, Delek Drilling - Limited Partnership had liabilities of US$1.35b due within 12 months, and liabilities of US$2.51b due beyond 12 months. On the other hand, it had cash of US$592.7m and US$247.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.02b.
Given this deficit is actually higher than the company's market capitalization of US$2.69b, we think shareholders really should watch Delek Drilling - Limited Partnership's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Delek Drilling - Limited Partnership's debt is 3.3 times its EBITDA, and its EBIT cover its interest expense 3.4 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The silver lining is that Delek Drilling - Limited Partnership grew its EBIT by 142% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Delek Drilling - Limited Partnership 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Delek Drilling - Limited Partnership reported free cash flow worth 7.9% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
On the face of it, Delek Drilling - Limited Partnership's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Delek Drilling - Limited Partnership stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 Delek Drilling - Limited Partnership has 3 warning signs (and 2 which make us uncomfortable) we think you should know about.
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.