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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that California Resources Corporation (NYSE:CRC) does use debt in its business. But should shareholders be worried about its use of debt?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is California Resources's Debt?
As you can see below, California Resources had US$5.16b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. And it doesn't have much cash, so its net debt is about the same.
A Look At California Resources's Liabilities
We can see from the most recent balance sheet that California Resources had liabilities of US$610.0m falling due within a year, and liabilities of US$5.92b due beyond that. Offsetting this, it had US$27.0m in cash and US$300.0m in receivables that were due within 12 months. So its liabilities total US$6.21b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$458.7m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, California Resources would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While we wouldn't worry about California Resources's net debt to EBITDA ratio of 4.8, we think its super-low interest cover of 1.5 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Looking on the bright side, California Resources boosted its EBIT by a silky 83% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine California Resources's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, California Resources saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both California Resources'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 it's pretty decent at growing its EBIT; that's encouraging. We're quite clear that we consider California Resources to be really rather risky, as a result of its balance sheet health. 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. Given the risks around California Resources's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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