Is Coterra Energy (NYSE:CTRA) Using Too Much Debt?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Coterra Energy Inc. (NYSE:CTRA) does carry debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Coterra Energy

What Is Coterra Energy's Debt?

As you can see below, Coterra Energy had US$2.16b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$956.0m in cash offsetting this, leading to net debt of about US$1.21b.

How Healthy Is Coterra Energy's Balance Sheet?

We can see from the most recent balance sheet that Coterra Energy had liabilities of US$1.66b falling due within a year, and liabilities of US$5.71b due beyond that. Offsetting these obligations, it had cash of US$956.0m as well as receivables valued at US$894.0m due within 12 months. So it has liabilities totalling US$5.52b more than its cash and near-term receivables, combined.

Coterra Energy has a very large market capitalization of US$19.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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.

Coterra Energy's net debt is only 0.32 times its EBITDA. And its EBIT covers its interest expense a whopping 45.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Coterra Energy's load is not too heavy, because its EBIT was down 59% over the last year. 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 ultimately the future profitability of the business will decide if Coterra Energy 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Coterra Energy produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Based on what we've seen Coterra Energy is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the elements mentioned above, it seems to us that Coterra Energy is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example - Coterra Energy has 2 warning signs we think you should be aware of.

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.

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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.