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. 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 ONE Gas, Inc. (NYSE:OGS) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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.
How Much Debt Does ONE Gas Carry?
As you can see below, at the end of September 2019, ONE Gas had US$1.68b of debt, up from US$1.47b a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.
A Look At ONE Gas's Liabilities
According to the last reported balance sheet, ONE Gas had liabilities of US$677.8m due within 12 months, and liabilities of US$2.75b due beyond 12 months. On the other hand, it had cash of US$12.6m and US$130.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.29b.
This deficit is considerable relative to its market capitalization of US$4.54b, so it does suggest shareholders should keep an eye on ONE Gas's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
ONE Gas's debt is 3.6 times its EBITDA, and its EBIT cover its interest expense 4.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Notably ONE Gas's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish 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 ONE 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, ONE Gas actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
We'd go so far as to say ONE Gas's conversion of EBIT to free cash flow was disappointing. Having said that, its ability to grow its EBIT isn't such a worry. It's also worth noting that ONE Gas is in the Gas Utilities industry, which is often considered to be quite defensive. Overall, we think it's fair to say that ONE Gas has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Over time, share prices tend to follow earnings per share, so if you're interested in ONE Gas, you may well want to click here to check an interactive graph of its earnings per share history.
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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