Occidental Petroleum (NYSE:OXY) Seems To Use Debt Quite Sensibly

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Occidental Petroleum Corporation (NYSE:OXY) makes use of debt. But the real question is whether this debt is making the company risky.

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Our analysis indicates that OXY is potentially undervalued!

What Is Occidental Petroleum's Net Debt?

As you can see below, Occidental Petroleum had US$22.0b of debt at June 2022, down from US$37.2b a year prior. However, it does have US$1.36b in cash offsetting this, leading to net debt of about US$20.7b.

A Look At Occidental Petroleum's Liabilities

According to the last reported balance sheet, Occidental Petroleum had liabilities of US$9.73b due within 12 months, and liabilities of US$36.7b due beyond 12 months. Offsetting these obligations, it had cash of US$1.36b as well as receivables valued at US$6.35b due within 12 months. So its liabilities total US$38.7b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Occidental Petroleum is worth a massive US$66.0b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Occidental Petroleum has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 11.7 times over. So we're pretty relaxed about its super-conservative use of debt. It was also good to see that despite losing money on the EBIT line last year, Occidental Petroleum turned things around in the last 12 months, delivering and EBIT of US$11b. 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 Occidental Petroleum 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Occidental Petroleum generated free cash flow amounting to a very robust 99% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Occidental Petroleum's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Occidental Petroleum can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Occidental Petroleum (of which 1 doesn't sit too well with us!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.