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

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 Chennai Petroleum Corporation Limited (NSE:CHENNPETRO) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Chennai Petroleum

How Much Debt Does Chennai Petroleum Carry?

You can click the graphic below for the historical numbers, but it shows that Chennai Petroleum had ₹74.7b of debt in September 2022, down from ₹104.6b, one year before. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Chennai Petroleum's Balance Sheet?

The latest balance sheet data shows that Chennai Petroleum had liabilities of ₹127.9b due within a year, and liabilities of ₹33.6b falling due after that. On the other hand, it had cash of ₹83.8m and ₹13.2b worth of receivables due within a year. So it has liabilities totalling ₹148.2b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the ₹32.1b 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 definitely think shareholders need to watch this one closely. At the end of the day, Chennai Petroleum would probably need a major re-capitalization if its creditors were to demand repayment.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Chennai Petroleum's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 17.7 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Chennai Petroleum grew its EBIT by 540% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is Chennai Petroleum's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent two years, Chennai Petroleum recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Chennai Petroleum's level of total liabilities has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think Chennai Petroleum's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Chennai Petroleum you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.