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. 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. Importantly, Whiting Petroleum Corporation (NYSE:WLL) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Whiting Petroleum's Debt?
The chart below, which you can click on for greater detail, shows that Whiting Petroleum had US$2.85b in debt in June 2019; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Whiting Petroleum's Balance Sheet?
According to the last reported balance sheet, Whiting Petroleum had liabilities of US$1.09b due within 12 months, and liabilities of US$2.48b due beyond 12 months. Offsetting these obligations, it had cash of US$6.68m as well as receivables valued at US$293.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.28b.
This deficit casts a shadow over the US$575.1m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, Whiting Petroleum would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Even though Whiting Petroleum's debt is only 2.2, its interest cover is really very low at 2.3. In large part that's it has so much depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) In any case, it's safe to say the company has meaningful debt. We also note that Whiting Petroleum improved its EBIT from a last year's loss to a positive US$433m. 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 Whiting 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, Whiting Petroleum recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
To be frank both Whiting Petroleum's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Whiting Petroleum has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given our concerns about Whiting Petroleum's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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