Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. We note that Petronet LNG Limited (NSE:PETRONET) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Petronet LNG
How Much Debt Does Petronet LNG Carry?
You can click the graphic below for the historical numbers, but it shows that Petronet LNG had ₹35.3b of debt in September 2021, down from ₹39.1b, one year before. However, it does have ₹60.2b in cash offsetting this, leading to net cash of ₹24.9b.
A Look At Petronet LNG's Liabilities
Zooming in on the latest balance sheet data, we can see that Petronet LNG had liabilities of ₹37.9b due within 12 months and liabilities of ₹50.2b due beyond that. On the other hand, it had cash of ₹60.2b and ₹21.6b worth of receivables due within a year. So its liabilities total ₹6.31b more than the combination of its cash and short-term receivables.
Given Petronet LNG has a market capitalization of ₹306.8b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Petronet LNG also has more cash than debt, so we're pretty confident it can manage its debt safely.
And we also note warmly that Petronet LNG grew its EBIT by 16% last year, making its debt load easier to handle. 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 company can only pay off debt with cold hard cash, not accounting profits. Petronet LNG may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Petronet LNG produced sturdy free cash flow equating to 79% 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 it is always sensible to look at a company's total liabilities, it is very reassuring that Petronet LNG has ₹24.9b in net cash. And it impressed us with free cash flow of ₹35b, being 79% of its EBIT. So is Petronet LNG's debt a risk? It doesn't seem so to us. 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. To that end, you should be aware of the 1 warning sign we've spotted with Petronet LNG .
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.