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

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.' 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. We note that Chennai Petroleum Corporation Limited (NSE:CHENNPETRO) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Chennai Petroleum

What Is Chennai Petroleum's Debt?

The image below, which you can click on for greater detail, shows that Chennai Petroleum had debt of ₹34.0b at the end of September 2023, a reduction from ₹74.7b 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

The latest balance sheet data shows that Chennai Petroleum had liabilities of ₹79.9b due within a year, and liabilities of ₹23.7b falling due after that. On the other hand, it had cash of ₹577.6m and ₹13.3b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹89.7b.

This deficit is considerable relative to its market capitalization of ₹93.3b, so it does suggest shareholders should keep an eye on Chennai Petroleum's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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 0.63. And its EBIT covers its interest expense a whopping 15.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Chennai Petroleum's EBIT dived 11%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Chennai 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. Over the most recent three years, Chennai Petroleum recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Chennai Petroleum's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We think that Chennai Petroleum's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Chennai Petroleum (of which 1 shouldn't be ignored!) you should know about.

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.