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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Imperial Oil Limited (TSE:IMO) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.
What Is Imperial Oil's Debt?
The image below, which you can click on for greater detail, shows that Imperial Oil had debt of CA$4.62b at the end of June 2019, a reduction from CA$5.19b over a year. However, it also had CA$1.09b in cash, and so its net debt is CA$3.54b.
How Healthy Is Imperial Oil's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Imperial Oil had liabilities of CA$4.21b due within 12 months and liabilities of CA$12.7b due beyond that. Offsetting this, it had CA$1.09b in cash and CA$3.13b in receivables that were due within 12 months. So its liabilities total CA$12.7b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Imperial Oil has a huge market capitalization of CA$25.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
Imperial Oil's net debt is only 0.73 times its EBITDA. And its EBIT covers its interest expense a whopping 121 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Imperial Oil grew its EBIT by 166% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Imperial Oil'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Imperial Oil actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
The good news is that Imperial Oil's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. Looking at the bigger picture, we think Imperial Oil's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. Over time, share prices tend to follow earnings per share, so if you're interested in Imperial Oil, 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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