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.' 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 Oil Refineries Ltd. (TLV:ORL) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
What Is Oil Refineries's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2021 Oil Refineries had US$1.68b of debt, an increase on US$1.54b, over one year. However, it also had US$727.8m in cash, and so its net debt is US$954.5m.
How Strong Is Oil Refineries' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Oil Refineries had liabilities of US$1.28b due within 12 months and liabilities of US$1.65b due beyond that. On the other hand, it had cash of US$727.8m and US$494.9m worth of receivables due within a year. So it has liabilities totalling US$1.70b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$960.3m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Oil Refineries would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Oil Refineries's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 2.5 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Notably, Oil Refineries made a loss at the EBIT level, last year, but improved that to positive EBIT of US$255m in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Oil Refineries will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Looking at the most recent year, Oil Refineries recorded free cash flow of 37% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
We'd go so far as to say Oil Refineries's level of total liabilities was disappointing. Having said that, its ability to grow its EBIT isn't such a worry. We're quite clear that we consider Oil Refineries to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Oil Refineries you should be aware of.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.