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. Importantly, Bharat Petroleum Corporation Limited (NSE:BPCL) does carry debt. But is this debt a concern to shareholders?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Bharat Petroleum's Net Debt?
The image below, which you can click on for greater detail, shows that Bharat Petroleum had debt of ₹433.0b at the end of September 2020, a reduction from ₹459.3b over a year. On the flip side, it has ₹128.1b in cash leading to net debt of about ₹304.9b.
How Healthy Is Bharat Petroleum's Balance Sheet?
According to the last reported balance sheet, Bharat Petroleum had liabilities of ₹553.8b due within 12 months, and liabilities of ₹541.0b due beyond 12 months. Offsetting these obligations, it had cash of ₹128.1b as well as receivables valued at ₹59.7b due within 12 months. So it has liabilities totalling ₹906.9b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its very significant market capitalization of ₹926.1b, so it does suggest shareholders should keep an eye on Bharat Petroleum's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Bharat Petroleum's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its strong interest cover of 18.4 times, makes us even more comfortable. One way Bharat Petroleum could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 18%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Bharat Petroleum can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Bharat Petroleum reported free cash flow worth 4.5% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Neither Bharat Petroleum's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Bharat Petroleum's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 4 warning signs for Bharat Petroleum that you should be aware of.
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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