Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We note that Peyto Exploration & Development Corp. (TSE:PEY) has debt on its balance sheet. But the real question is whether this debt makes the business risky.
What risk does debt carry?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case, a company can go bankrupt if it cannot pay its creditors. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first thing to do when considering how much debt a business has is to look at its cash flow and debt together.
Check out our latest analysis for Peyto Exploration & Development
What is Peyto Exploration & Development’s net debt?
You can click on the chart below for historical numbers, but it shows that in March 2022, Peyto Exploration & Development had C$1.33 billion in debt, an increase from C$1.17 billion. Canadians, over one year. Net debt is about the same, since she doesn’t have a lot of cash.
A look at the passives of Peyto Exploration & Development
Zooming in on the latest balance sheet data, we can see that Peyto Exploration & Development had liabilities of C$492.2 million due within 12 months and liabilities of C$1.73 billion due beyond. In compensation for these obligations, it had cash of 3.57 million Canadian dollars as well as receivables valued at 150.0 million Canadian dollars maturing within 12 months. It therefore has liabilities totaling C$2.07 billion more than its cash and short-term receivables, combined.
This deficit is considerable compared to its market capitalization of 2.17 billion Canadian dollars, so it suggests that shareholders monitor the use of debt by Peyto Exploration & Development. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Peyto Exploration & Development’s net debt is at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense at just 6.1 times last year. While that doesn’t worry us too much, it does suggest that interest payments are a bit of a burden. Notably, Peyto Exploration & Development’s EBIT launched higher than Elon Musk, gaining a whopping 279% from a year ago. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Peyto Exploration & Development can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the last three years, Peyto Exploration & Development has recorded a free cash flow of 38% of its EBIT, which is lower than expected. It’s not great when it comes to paying off debt.
Our point of view
The level of Peyto Exploration & Development’s total liabilities and the conversion of EBIT to free cash flow are certainly weighing on her, in our view. But the good news is that it looks like it could easily increase its EBIT. From all the angles mentioned above, it seems to us that Peyto Exploration & Development is a bit of a risky investment due to its leverage. Not all risk is bad, as it can increase stock price returns if it pays off, but this leverage risk is worth keeping in mind. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. To do this, you need to find out about the 5 warning signs we spotted some with Peyto Exploration & Development (including 1 which is a bit unpleasant).
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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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.