These 4 Measures Indicate That Chennai Petroleum (NSE:CHENNPETRO) Is Using Debt Reasonably Well

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, Chennai Petroleum Corporation Limited (NSE:CHENNPETRO) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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

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 ₹34.2b at the end of September 2023, a reduction from ₹74.9b over a year. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is Chennai Petroleum's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Chennai Petroleum had liabilities of ₹79.9b due within 12 months and liabilities of ₹23.7b due beyond that. Offsetting these obligations, it had cash of ₹577.6m as well as receivables valued at ₹13.3b due within 12 months. So it has liabilities totalling ₹89.7b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of ₹126.6b, so it does suggest shareholders should keep an eye on Chennai Petroleum's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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 0.60. And its EBIT covers its interest expense a whopping 20.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Chennai Petroleum saw its EBIT decline by 4.3% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Chennai Petroleum can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the most recent three years, Chennai Petroleum recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Chennai Petroleum's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that Chennai Petroleum is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for Chennai Petroleum you should be aware of, and 1 of them shouldn't be ignored.

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.