Here's Why Nexen (KRX:005720) Is Weighed Down By Its Debt Load

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Nexen Corporation (KRX:005720) does use debt in its business. 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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Nexen

What Is Nexen's Net Debt?

As you can see below, at the end of December 2020, Nexen had ₩1.45t of debt, up from ₩1.25t a year ago. Click the image for more detail. However, because it has a cash reserve of ₩512.7b, its net debt is less, at about ₩936.9b.

A Look At Nexen's Liabilities

We can see from the most recent balance sheet that Nexen had liabilities of ₩849.1b falling due within a year, and liabilities of ₩1.35t due beyond that. On the other hand, it had cash of ₩512.7b and ₩428.9b worth of receivables due within a year. So it has liabilities totalling ₩1.26t more than its cash and near-term receivables, combined.

This deficit casts a shadow over the ₩267.8b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Nexen would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Nexen's debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 5.1 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Importantly, Nexen's EBIT fell a jaw-dropping 72% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Nexen 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Nexen created free cash flow amounting to 19% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both Nexen'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 at least its interest cover is not so bad. After considering the datapoints discussed, we think Nexen has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For instance, we've identified 4 warning signs for Nexen (2 are a bit unpleasant) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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