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. We can see that National Fuel Gas Company (NYSE:NFG) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is National Fuel Gas's Debt?
The image below, which you can click on for greater detail, shows that at September 2020 National Fuel Gas had debt of US$2.66b, up from US$2.19b in one year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is National Fuel Gas's Balance Sheet?
According to the last reported balance sheet, National Fuel Gas had liabilities of US$459.6m due within 12 months, and liabilities of US$4.53b due beyond 12 months. On the other hand, it had cash of US$20.5m and US$164.7m worth of receivables due within a year. So it has liabilities totalling US$4.81b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's US$3.74b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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.
National Fuel Gas's debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 3.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even more troubling is the fact that National Fuel Gas actually let its EBIT decrease by 7.5% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. 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 National Fuel Gas 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, National Fuel Gas burned a lot of cash. 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.
To be frank both National Fuel Gas's level of total liabilities and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. It's also worth noting that National Fuel Gas is in the Gas Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that National Fuel Gas's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For instance, we've identified 3 warning signs for National Fuel Gas (1 shouldn't be ignored) you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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