South West Pinnacle Exploration (NSE:SOUTHWEST) Has A Somewhat Strained Balance Sheet

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that South West Pinnacle Exploration Limited (NSE:SOUTHWEST) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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

How Much Debt Does South West Pinnacle Exploration Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 South West Pinnacle Exploration had ₹574.0m of debt, an increase on ₹392.6m, over one year. On the flip side, it has ₹92.5m in cash leading to net debt of about ₹481.5m.

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

Zooming in on the latest balance sheet data, we can see that South West Pinnacle Exploration had liabilities of ₹636.5m due within 12 months and liabilities of ₹168.2m due beyond 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.

Given South West Pinnacle Exploration has a market capitalization of ₹1.47b, 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

South West Pinnacle Exploration's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 3.0 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. If South West Pinnacle Exploration can keep growing EBIT at last year's rate of 10% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, South West Pinnacle Exploration burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

South West Pinnacle Exploration's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its EBIT growth rate is relatively strong. Taking the abovementioned factors together we do think South West Pinnacle Exploration's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for South West Pinnacle Exploration (of which 1 shouldn't be ignored!) you should know about.

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. 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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