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. 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. As with many other companies PrimeEnergy Resources Corporation (NASDAQ:PNRG) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is PrimeEnergy Resources’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 PrimeEnergy Resources had debt of US$61.5m, up from US$57.5 in one year. However, because it has a cash reserve of US$4.36m, its net debt is less, at about US$57.1m.
How Strong Is PrimeEnergy Resources’s Balance Sheet?
The latest balance sheet data shows that PrimeEnergy Resources had liabilities of US$20.8m due within a year, and liabilities of US$115.6m falling due after that. Offsetting these obligations, it had cash of US$4.36m as well as receivables valued at US$17.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$114.3m.
PrimeEnergy Resources has a market capitalization of US$298.5m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While PrimeEnergy Resources’s low debt to EBITDA ratio of 0.98 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.4 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. It is well worth noting that PrimeEnergy Resources’s EBIT shot up like bamboo after rain, gaining 45% in the last twelve months. That’ll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is PrimeEnergy Resources’s earnings that will influence how the balance sheet holds up in the future. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last two years, PrimeEnergy Resources actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
On our analysis PrimeEnergy Resources’s EBIT growth rate should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. In particular, conversion of EBIT to free cash flow gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about PrimeEnergy Resources’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 2 warning signs for PrimeEnergy Resources that you should be aware of before investing here.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.