Is Chennai Petroleum (NSE:CHENNPETRO) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Chennai Petroleum Corporation Limited (NSE:CHENNPETRO) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Chennai Petroleum

What Is Chennai Petroleum's Net Debt?

The image below, which you can click on for greater detail, shows that Chennai Petroleum had debt of ₹74.9b at the end of September 2022, a reduction from ₹104.7b over a year. And it doesn't have much cash, so its net debt is about the same.

A Look At Chennai Petroleum's Liabilities

Zooming in on the latest balance sheet data, we can see that Chennai Petroleum had liabilities of ₹127.9b due within 12 months and liabilities of ₹33.6b due beyond that. On the other hand, it had cash of ₹83.8m and ₹13.2b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹148.2b.

The deficiency here weighs heavily on the ₹40.1b 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'd watch its balance sheet closely, without a doubt. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Chennai Petroleum has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 16.2 times the size. 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 327% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent two years, Chennai Petroleum recorded free cash flow of 49% 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. To wit both its interest cover and EBIT growth rate were encouraging signs. We think that Chennai Petroleum's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. We've identified 2 warning signs with Chennai Petroleum , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.