Earthstone Energy (NYSE:ESTE) Takes On Some Risk With Its Use Of Debt

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.' 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. We note that Earthstone Energy, Inc. (NYSE:ESTE) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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, 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.

View our latest analysis for Earthstone Energy

How Much Debt Does Earthstone Energy Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2023 Earthstone Energy had US$991.9m of debt, an increase on US$624.2m, over one year. And it doesn't have much cash, so its net debt is about the same.

A Look At Earthstone Energy's Liabilities

The latest balance sheet data shows that Earthstone Energy had liabilities of US$385.0m due within a year, and liabilities of US$1.19b falling due after that. Offsetting these obligations, it had cash of US$482.0k as well as receivables valued at US$161.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.41b.

This deficit is considerable relative to its market capitalization of US$1.75b, so it does suggest shareholders should keep an eye on Earthstone Energy's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Earthstone Energy's net debt is only 0.71 times its EBITDA. And its EBIT easily covers its interest expense, being 11.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Earthstone Energy grew its EBIT by 2,033% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Earthstone Energy'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 last two years, Earthstone Energy saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

While Earthstone Energy's conversion of EBIT to free cash flow has us nervous. For example, its EBIT growth rate and interest cover give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it does seem to us that Earthstone Energy is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Earthstone Energy is showing 3 warning signs in our investment analysis , and 1 of those 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.

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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.