Is GP Petroleums (NSE:GULFPETRO) Using Too Much Debt?

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.' 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 GP Petroleums Limited (NSE:GULFPETRO) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for GP Petroleums

What Is GP Petroleums's Net Debt?

You can click the graphic below for the historical numbers, but it shows that GP Petroleums had ₹633.2m of debt in September 2020, down from ₹1.31b, one year before. Net debt is about the same, since the it doesn't have much cash.

A Look At GP Petroleums' Liabilities

Zooming in on the latest balance sheet data, we can see that GP Petroleums had liabilities of ₹1.07b due within 12 months and liabilities of ₹85.7m due beyond that. Offsetting these obligations, it had cash of ₹11.7m as well as receivables valued at ₹837.2m due within 12 months. So its liabilities total ₹310.5m more than the combination of its cash and short-term receivables.

Of course, GP Petroleums has a market capitalization of ₹2.40b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

GP Petroleums has a debt to EBITDA ratio of 2.7, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 10.9 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Shareholders should be aware that GP Petroleums's EBIT was down 38% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is GP Petroleums's earnings that will influence how the balance sheet holds up in the future. 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, GP Petroleums recorded free cash flow of 27% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

GP Petroleums's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its interest cover was refreshing. When we consider all the factors discussed, it seems to us that GP Petroleums is taking some risks with its use of debt. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - GP Petroleums has 3 warning signs we think you should be aware of.

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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