Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Petronet LNG Limited (NSE:PETRONET) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Petronet LNG
What Is Petronet LNG's Debt?
The chart below, which you can click on for greater detail, shows that Petronet LNG had ₹33.5b in debt in March 2023; about the same as the year before. But it also has ₹65.6b in cash to offset that, meaning it has ₹32.1b net cash.
How Strong Is Petronet LNG's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Petronet LNG had liabilities of ₹29.0b due within 12 months and liabilities of ₹45.9b due beyond that. On the other hand, it had cash of ₹65.6b and ₹38.4b worth of receivables due within a year. So it can boast ₹29.1b more liquid assets than total liabilities.
This surplus suggests that Petronet LNG has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Petronet LNG has more cash than debt is arguably a good indication that it can manage its debt safely.
But the other side of the story is that Petronet LNG saw its EBIT decline by 6.4% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Petronet LNG'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. While Petronet LNG has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Petronet LNG produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Summing Up
While we empathize with investors who find debt concerning, you should keep in mind that Petronet LNG has net cash of ₹32.1b, as well as more liquid assets than liabilities. So we don't have any problem with Petronet LNG's use of debt. 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. We've identified 1 warning sign with Petronet LNG , and understanding them should be part of your investment process.
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.
About NSEI:PETRONET
Petronet LNG
Engages in the import, storage, regasification, and supply of liquefied natural gas (LNG) in India.
Solid track record with excellent balance sheet and pays a dividend.