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. We note that ConocoPhillips (NYSE:COP) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does ConocoPhillips Carry?
As you can see below, ConocoPhillips had US$13.7b of debt, at March 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$8.19b in cash, and so its net debt is US$5.53b.
How Healthy Is ConocoPhillips’s Balance Sheet?
The latest balance sheet data shows that ConocoPhillips had liabilities of US$6.08b due within a year, and liabilities of US$27.6b falling due after that. Offsetting this, it had US$8.19b in cash and US$2.26b in receivables that were due within 12 months. So its liabilities total US$23.2b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because ConocoPhillips is worth a massive US$45.1b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). 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).
ConocoPhillips’s net debt is only 0.46 times its EBITDA. And its EBIT covers its interest expense a whopping 10.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact ConocoPhillips’s saving grace is its low debt levels, because its EBIT has tanked 39% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 ConocoPhillips’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, ConocoPhillips recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
ConocoPhillips’s EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its net debt to EBITDA was re-invigorating. We think that ConocoPhillips’s debt does make it a bit risky, after considering the aforementioned data points together. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. To that end, you should be aware of the 4 warning signs we’ve spotted with ConocoPhillips .
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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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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