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David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Laredo Petroleum, Inc. (NYSE:LPI) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Laredo Petroleum Carry?
As you can see below, at the end of June 2019, Laredo Petroleum had US$1.03b of debt, up from US$902.7m a year ago. Click the image for more detail. However, it also had US$55.8m in cash, and so its net debt is US$973.7m.
How Healthy Is Laredo Petroleum's Balance Sheet?
According to the last reported balance sheet, Laredo Petroleum had liabilities of US$170.7m due within 12 months, and liabilities of US$1.10b due beyond 12 months. Offsetting this, it had US$55.8m in cash and US$73.5m in receivables that were due within 12 months. So it has liabilities totalling US$1.15b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$706.0m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt At the end of the day, Laredo 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.
Laredo Petroleum has net debt worth 1.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.5 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. It is well worth noting that Laredo Petroleum's EBIT shot up like bamboo after rain, gaining 75% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Laredo 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.
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. During the last three years, Laredo Petroleum burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Laredo Petroleum's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Laredo Petroleum has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Laredo Petroleum's earnings per share history for free.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.