Chennai Petroleum (NSE:CHENNPETRO) Has A Somewhat Strained Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Chennai Petroleum Corporation Limited (NSE:CHENNPETRO) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Chennai Petroleum

What Is Chennai Petroleum's Debt?

The chart below, which you can click on for greater detail, shows that Chennai Petroleum had ₹86.5b in debt in March 2021; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.

A Look At Chennai Petroleum's Liabilities

According to the last reported balance sheet, Chennai Petroleum had liabilities of ₹93.6b due within 12 months, and liabilities of ₹32.5b due beyond 12 months. Offsetting this, it had ₹226.8m in cash and ₹2.33b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹123.6b.

The deficiency here weighs heavily on the ₹16.8b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Chennai Petroleum would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Chennai Petroleum's debt is 4.1 times its EBITDA, and its EBIT cover its interest expense 4.4 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, the silver lining was that Chennai Petroleum achieved a positive EBIT of ₹16b in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Chennai Petroleum 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, Chennai Petroleum recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

To be frank both Chennai Petroleum's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. After considering the datapoints discussed, we think Chennai Petroleum has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. For example - Chennai Petroleum has 1 warning sign we think 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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This article by Simply Wall St is general in nature. 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.
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