Is South West Pinnacle Exploration (NSE:SOUTHWEST) Using Too Much Debt?

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 can see that South West Pinnacle Exploration Limited (NSE:SOUTHWEST) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for South West Pinnacle Exploration

What Is South West Pinnacle Exploration's Net Debt?

The chart below, which you can click on for greater detail, shows that South West Pinnacle Exploration had ₹375.5m in debt in September 2020; about the same as the year before. However, it does have ₹92.5m in cash offsetting this, leading to net debt of about ₹283.0m.

How Strong Is South West Pinnacle Exploration's Balance Sheet?

The latest balance sheet data shows that South West Pinnacle Exploration had liabilities of ₹636.5m due within a year, and liabilities of ₹168.2m falling due after that. Offsetting these obligations, it had cash of ₹92.5m as well as receivables valued at ₹542.3m due within 12 months. So it has liabilities totalling ₹169.9m more than its cash and near-term receivables, combined.

Since publicly traded South West Pinnacle Exploration shares are worth a total of ₹1.19b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 1.5 times EBITDA, it is initially surprising to see that South West Pinnacle Exploration's EBIT has low interest coverage of 2.5 times. So one way or the other, it's clear the debt levels are not trivial. The bad news is that South West Pinnacle Exploration saw its EBIT decline by 17% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since South West Pinnacle Exploration will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, South West Pinnacle Exploration burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, South West Pinnacle Exploration's EBIT growth rate left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Overall, we think it's fair to say that South West Pinnacle Exploration has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Like risks, for instance. Every company has them, and we've spotted 5 warning signs for South West Pinnacle Exploration (of which 1 is significant!) you should know about.

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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This article by Simply Wall St is general in nature. 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.
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