Callon Petroleum (NYSE:CPE) Has A Somewhat Strained Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Callon Petroleum Company (NYSE:CPE) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Callon Petroleum

How Much Debt Does Callon Petroleum Carry?

You can click the graphic below for the historical numbers, but it shows that Callon Petroleum had US$1.95b of debt in September 2023, down from US$2.37b, one year before. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Callon Petroleum's Balance Sheet?

We can see from the most recent balance sheet that Callon Petroleum had liabilities of US$749.8m falling due within a year, and liabilities of US$2.12b due beyond that. On the other hand, it had cash of US$3.46m and US$262.4m worth of receivables due within a year. So it has liabilities totalling US$2.60b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$2.05b, we think shareholders really should watch Callon Petroleum's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Callon Petroleum has a low net debt to EBITDA ratio of only 1.4. And its EBIT easily covers its interest expense, being 12.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Callon Petroleum's saving grace is its low debt levels, because its EBIT has tanked 33% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Callon Petroleum can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Callon Petroleum reported free cash flow worth 7.2% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

We'd go so far as to say Callon Petroleum's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Callon Petroleum to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 4 warning signs we've spotted with Callon Petroleum (including 1 which is a bit concerning) .

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.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.