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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Panhandle Oil and Gas Inc. (NYSE:PHX) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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.
What Is Panhandle Oil and Gas’s Net Debt?
The chart below, which you can click on for greater detail, shows that Panhandle Oil and Gas had US$44.1m in debt in March 2019; about the same as the year before. And it doesn’t have much cash, so its net debt is about the same.
A Look At Panhandle Oil and Gas’s Liabilities
According to the last reported balance sheet, Panhandle Oil and Gas had liabilities of US$1.94m due within 12 months, and liabilities of US$69.0m due beyond 12 months. On the other hand, it had cash of US$505.0k and US$6.96m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$63.5m.
Panhandle Oil and Gas has a market capitalization of US$210.1m, so it could very likely ameliorate its balance sheet if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Since Panhandle Oil and Gas does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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.
Panhandle Oil and Gas’s net debt is sitting at a very reasonable 1.85 times its EBITDA, while its EBIT covered its interest expense just 3.79 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. We saw Panhandle Oil and Gas grow its EBIT by 4.5% in the last twelve months. That’s far from incredible but it is a good thing, when it comes to paying off debt. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Panhandle Oil and Gas’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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, Panhandle Oil and Gas reported free cash flow worth 3.1% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Panhandle Oil and Gas’s conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to grow its EBIT isn’t too shabby at all. Taking the abovementioned factors together we do think Panhandle Oil and Gas’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.