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

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. Importantly, Oil Refineries Ltd. (TLV:ORL) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out the opportunities and risks within the IL Oil and Gas industry.

What Is Oil Refineries's Net Debt?

The image below, which you can click on for greater detail, shows that Oil Refineries had debt of US$1.34b at the end of September 2022, a reduction from US$1.68b over a year. However, it also had US$594.1m in cash, and so its net debt is US$745.9m.

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$1.43b due within 12 months and liabilities of US$1.52b due beyond that. On the other hand, it had cash of US$594.1m and US$860.8m worth of receivables due within a year. So it has liabilities totalling US$1.50b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$1.24b, we think shareholders really should watch Oil Refineries'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). 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).

Looking at its net debt to EBITDA of 1.0 and interest cover of 5.4 times, it seems to us that Oil Refineries is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Pleasingly, Oil Refineries is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 126% gain in the last twelve months. 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 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. Over the most recent two years, Oil Refineries recorded free cash flow worth 53% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

When it comes to the balance sheet, the standout positive for Oil Refineries was the fact that it seems able to grow its EBIT confidently. But the other factors we noted above weren't so encouraging. In particular, level of total liabilities gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Oil Refineries's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Be aware that Oil Refineries is showing 3 warning signs in our investment analysis , and 1 of those is significant...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.