Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘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. Importantly, Oasis Petroleum Inc. (NASDAQ:OAS) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Oasis Petroleum’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Oasis Petroleum had debt of US$2.80b, up from US$2.63b in one year. Net debt is about the same, since the it doesn’t have much cash.
How Strong Is Oasis Petroleum’s Balance Sheet?
We can see from the most recent balance sheet that Oasis Petroleum had liabilities of US$593.9m falling due within a year, and liabilities of US$3.17b due beyond that. Offsetting this, it had US$19.4m in cash and US$381.6m in receivables that were due within 12 months. So it has liabilities totalling US$3.37b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$716.5m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Oasis Petroleum would probably need a major re-capitalization if its creditors were to demand repayment.
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.
Oasis Petroleum has net debt worth 2.3 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 2.7 times the interest expense. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. Pleasingly, Oasis Petroleum is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 306% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Oasis Petroleum can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Oasis Petroleum burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Oasis Petroleum’s conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at growing its EBIT; that’s encouraging. We’re quite clear that we consider Oasis Petroleum to be really rather risky, as a result of its balance sheet health. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. 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. Case in point: We’ve spotted 3 warning signs for Oasis Petroleum you should be aware of, and 1 of them makes us a bit uncomfortable.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned.
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