Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Centennial Resource Development, Inc. (NASDAQ:CDEV) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Centennial Resource Development's Net Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Centennial Resource Development had debt of US$880.9m, up from US$390.9m in one year. On the flip side, it has US$89.5m in cash leading to net debt of about US$791.4m.
How Healthy Is Centennial Resource Development's Balance Sheet?
We can see from the most recent balance sheet that Centennial Resource Development had liabilities of US$274.4m falling due within a year, and liabilities of US$962.6m due beyond that. On the other hand, it had cash of US$89.5m and US$114.1m worth of receivables due within a year. So its liabilities total US$1.03b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of US$1.39b, so it does suggest shareholders should keep an eye on Centennial Resource Development's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
With net debt sitting at just 1.2 times EBITDA, Centennial Resource Development is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.5 times the interest expense over the last year. And we also note warmly that Centennial Resource Development grew its EBIT by 13% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Centennial Resource Development can strengthen its balance sheet over time. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, Centennial Resource Development 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.
Centennial Resource Development's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to cover its interest expense with its EBIT isn't too shabby at all. Taking the abovementioned factors together we do think Centennial Resource Development's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Over time, share prices tend to follow earnings per share, so if you're interested in Centennial Resource Development, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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