These 4 Measures Indicate That Earthstone Energy (NYSE:ESTE) Is Using Debt Extensively

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.' 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, Earthstone Energy, Inc. (NYSE:ESTE) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Earthstone Energy

How Much Debt Does Earthstone Energy Carry?

The image below, which you can click on for greater detail, shows that at June 2022 Earthstone Energy had debt of US$932.8m, up from US$241.6m in one year. Net debt is about the same, since the it doesn't have much cash.

A Look At Earthstone Energy's Liabilities

We can see from the most recent balance sheet that Earthstone Energy had liabilities of US$432.5m falling due within a year, and liabilities of US$1.04b due beyond that. On the other hand, it had cash of US$482.0k and US$252.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.22b.

This deficit is considerable relative to its market capitalization of US$2.01b, 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Earthstone Energy's moderate net debt to EBITDA ratio ( being 2.0), indicates prudence when it comes to debt. And its strong interest cover of 11.1 times, makes us even more comfortable. Notably, Earthstone Energy made a loss at the EBIT level, last year, but improved that to positive EBIT of US$318m in the last twelve months. 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 Earthstone Energy 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Earthstone Energy saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Earthstone Energy's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Earthstone Energy's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Earthstone Energy (of which 2 don't sit too well with us!) you should know about.

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. 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.