Stock Analysis

We Think Oil and Natural Gas (NSE:ONGC) Is Taking Some Risk With Its Debt

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NSEI:ONGC
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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, Oil and Natural Gas Corporation Limited (NSE:ONGC) does carry debt. But the real question is whether this debt is making the company risky.

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. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.

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What Is Oil and Natural Gas's Net Debt?

The image below, which you can click on for greater detail, shows that Oil and Natural Gas had debt of ₹894.6b at the end of September 2020, a reduction from ₹949.6b over a year. On the flip side, it has ₹250.3b in cash leading to net debt of about ₹644.3b.

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NSEI:ONGC Debt to Equity History December 28th 2020

A Look At Oil and Natural Gas's Liabilities

We can see from the most recent balance sheet that Oil and Natural Gas had liabilities of ₹1.19t falling due within a year, and liabilities of ₹1.59t due beyond that. Offsetting these obligations, it had cash of ₹250.3b as well as receivables valued at ₹123.3b due within 12 months. So it has liabilities totalling ₹2.40t more than its cash and near-term receivables, combined.

This deficit casts a shadow over the ₹1.17t company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Oil and Natural Gas 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). 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).

Oil and Natural Gas's net debt is only 1.5 times its EBITDA. And its EBIT easily covers its interest expense, being 56.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Oil and Natural Gas's saving grace is its low debt levels, because its EBIT has tanked 61% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Oil and Natural Gas's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Oil and Natural Gas's free cash flow amounted to 40% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Oil and Natural Gas's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Oil and Natural Gas to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 4 warning signs for Oil and Natural Gas that you should be aware of before investing here.

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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