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. Importantly, Birchcliff Energy Ltd. (TSE:BIR) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Birchcliff Energy Carry?
As you can see below, Birchcliff Energy had CA$672.0m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn't have much cash.
A Look At Birchcliff Energy's Liabilities
According to the last reported balance sheet, Birchcliff Energy had liabilities of CA$140.2m due within 12 months, and liabilities of CA$927.2m due beyond 12 months. Offsetting this, it had CA$21.0k in cash and CA$47.9m in receivables that were due within 12 months. So its liabilities total CA$1.02b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CA$534.5m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Birchcliff Energy would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Birchcliff Energy's net debt is sitting at a very reasonable 1.9 times its EBITDA, while its EBIT covered its interest expense just 4.7 times last year. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. We note that Birchcliff Energy grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Birchcliff Energy'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Birchcliff Energy burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both Birchcliff Energy'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 on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider Birchcliff Energy to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Given our hesitation about the stock, it would be good to know if Birchcliff Energy insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.