Is Oil Refineries (TLV:ORL) Using Too Much Debt?

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.' 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. We note that Oil Refineries Ltd. (TLV:ORL) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Oil Refineries

What Is Oil Refineries's Debt?

As you can see below, Oil Refineries had US$1.58b of debt, at December 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$669.4m, its net debt is less, at about US$906.6m.

A Look At Oil Refineries' Liabilities

Zooming in on the latest balance sheet data, we can see that Oil Refineries had liabilities of US$1.37b due within 12 months and liabilities of US$1.65b due beyond that. Offsetting this, it had US$669.4m in cash and US$633.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.71b.

Given this deficit is actually higher than the company's market capitalization of US$1.25b, we think shareholders really should watch Oil Refineries'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.

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 1.6 times its EBITDA, while its EBIT covered its interest expense just 4.5 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. We also note that Oil Refineries improved its EBIT from a last year's loss to a positive US$417m. When analysing debt levels, the balance sheet is the obvious place to start. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Oil Refineries saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Oil Refineries's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Overall, it seems to us that Oil Refineries's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Oil Refineries you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.