Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We can see that Hindustan Petroleum Corporation Limited (NSE: HINDPETRO) uses debt in its business. But does this debt worry shareholders?
Why is debt risky?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. In the worst case, 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 at a low price, thereby permanently diluting shareholders. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
Check out our latest analysis for Hindustan Petroleum
What is Hindustan Petroleum’s debt?
The image below, which you can click on for more details, shows that as of March 2022, Hindustan Petroleum had a debt of ₹449.8 billion, up from ₹406.8 billion in a year. However, he has ₹56.3 billion in cash to offset this, resulting in a net debt of around ₹393.5 billion.
A look at the responsibilities of Hindustan Petroleum
Latest balance sheet data shows that Hindustan Petroleum had liabilities of ₹714.4 billion due within one year, and liabilities of ₹417.8 billion falling due thereafter. As compensation for these obligations, it had cash of ₹56.3 billion as well as receivables valued at ₹65.0 billion due within 12 months. Thus, its liabilities total 1.01t more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the ₹316.7 billion business itself, like a child struggling under the weight of a huge backpack full of books, his sports gear and a trumpet. So we definitely think shareholders need to watch this one closely. Ultimately, Hindustan Petroleum would likely need a major recapitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without amortization and depreciation expense.
Hindustan Petroleum has a debt to EBITDA ratio of 3.8 and its EBIT has covered its interest expense 6.3 times. Taken together, this implies that, while we wouldn’t like to see debt levels increase, we think he can manage his current leverage. Shareholders should know that Hindustan Petroleum’s EBIT fell by 50% last year. If this earnings trend continues, paying off debt will be about as easy as herding cats on a roller coaster. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Hindustan Petroleum’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Hindustan Petroleum has created free cash flow amounting to 5.7% of its EBIT, an interest-free performance. For us, such a low cash conversion creates a bit of paranoia about the ability to extinguish the debt.
Our point of view
At first glance, Hindustan Petroleum’s EBIT growth rate left us hesitant about the stock, and its level of total liabilities was no more appealing than the single empty restaurant on the busiest night of the year. . That said, its ability to cover its interest costs with its EBIT is not so worrying. After reviewing the data points discussed, we believe that Hindustan Petroleum has too much debt. While some investors like this kind of risky play, it’s definitely not our cup of tea. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Example: we have identified 3 warning signs for Hindustan Petroleum you should be aware.
Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.