Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 Diamondback Energy, Inc. (NASDAQ:FANG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Diamondback Energy Carry?
The image below, which you can click on for greater detail, shows that at September 2019 Diamondback Energy had debt of US$4.74b, up from US$2.33b in one year. However, because it has a cash reserve of US$100.0m, its net debt is less, at about US$4.64b.
How Strong Is Diamondback Energy’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Diamondback Energy had liabilities of US$1.18b due within 12 months and liabilities of US$6.88b due beyond that. Offsetting this, it had US$100.0m in cash and US$538.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.43b.
While this might seem like a lot, it is not so bad since Diamondback Energy has a huge market capitalization of US$12.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With a debt to EBITDA ratio of 1.7, Diamondback Energy uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.2 times its interest expenses harmonizes with that theme. It is well worth noting that Diamondback Energy’s EBIT shot up like bamboo after rain, gaining 78% in the last twelve months. That’ll make it easier to manage its debt. 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 Diamondback Energy’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
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. Over the last three years, Diamondback Energy saw substantial negative free cash flow, in total. 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.
Neither Diamondback Energy’s ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Diamondback Energy is a somewhat risky investment as a result of its debt. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Given our hesitation about the stock, it would be good to know if Diamondback Energy insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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