We Think Bharat Petroleum (NSE:BPCL) Is Taking Some Risk With Its 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.' 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. Importantly, Bharat Petroleum Corporation Limited (NSE:BPCL) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Bharat Petroleum

How Much Debt Does Bharat Petroleum Carry?

The image below, which you can click on for greater detail, shows that at September 2021 Bharat Petroleum had debt of ₹582.8b, up from ₹492.7b in one year. However, it does have ₹170.5b in cash offsetting this, leading to net debt of about ₹412.3b.

A Look At Bharat Petroleum's Liabilities

According to the last reported balance sheet, Bharat Petroleum had liabilities of ₹842.4b due within 12 months, and liabilities of ₹541.6b due beyond 12 months. Offsetting these obligations, it had cash of ₹170.5b as well as receivables valued at ₹73.7b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.14t.

When you consider that this deficiency exceeds the company's huge ₹781.6b market capitalization, you might well be inclined to review the balance sheet intently. 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.

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.

With a debt to EBITDA ratio of 2.1, Bharat Petroleum uses debt artfully but responsibly. And the alluring interest cover (EBIT of 9.9 times interest expense) certainly does not do anything to dispel this impression. We note that Bharat Petroleum grew its EBIT by 27% in the last year, and that should make it easier to pay down debt, going forward. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Bharat Petroleum recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Bharat Petroleum's level of total liabilities has us nervous. To wit both its EBIT growth rate and interest cover were encouraging signs. When we consider all the factors discussed, it seems to us that Bharat Petroleum is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Bharat Petroleum has 4 warning signs (and 1 which is concerning) we think 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.