Hindustan Petroleum (NSE:HINDPETRO) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, '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, Hindustan Petroleum Corporation Limited (NSE:HINDPETRO) does carry debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Hindustan Petroleum

How Much Debt Does Hindustan Petroleum Carry?

As you can see below, Hindustan Petroleum had ₹401.8b of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have ₹79.7b in cash offsetting this, leading to net debt of about ₹322.1b.

A Look At Hindustan Petroleum's Liabilities

According to the last reported balance sheet, Hindustan Petroleum had liabilities of ₹623.8b due within 12 months, and liabilities of ₹337.0b due beyond 12 months. On the other hand, it had cash of ₹79.7b and ₹70.0b worth of receivables due within a year. So its liabilities total ₹811.1b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the ₹412.2b 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, Hindustan Petroleum would probably need a major re-capitalization if its creditors were to demand repayment.

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

Hindustan Petroleum's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its commanding EBIT of 12.8 times its interest expense, implies the debt load is as light as a peacock feather. Notably, Hindustan Petroleum's EBIT launched higher than Elon Musk, gaining a whopping 291% on last year. 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 Hindustan 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Hindustan Petroleum saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Hindustan Petroleum's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Hindustan Petroleum's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For example, we've discovered 3 warning signs for Hindustan Petroleum (1 shouldn't be ignored!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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