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 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. We note that Cheniere Energy, Inc. (NYSEMKT:LNG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Cheniere Energy Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Cheniere Energy had debt of US$30.0b, up from US$26.9b in one year. However, it does have US$2.37b in cash offsetting this, leading to net debt of about US$27.7b.
How Strong Is Cheniere Energy's Balance Sheet?
The latest balance sheet data shows that Cheniere Energy had liabilities of US$2.21b due within a year, and liabilities of US$30.3b falling due after that. Offsetting these obligations, it had cash of US$2.37b as well as receivables valued at US$433.0m due within 12 months. So it has liabilities totalling US$29.7b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$16.4b 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 definitely think shareholders need to watch this one closely. At the end of the day, Cheniere Energy 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Cheniere Energy shareholders face the double whammy of a high net debt to EBITDA ratio (10.8), and fairly weak interest coverage, since EBIT is just 1.6 times the interest expense. This means we'd consider it to have a heavy debt load. Fortunately, Cheniere Energy grew its EBIT by 8.3% in the last year, slowly shrinking its debt relative to earnings. 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 Cheniere Energy 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Cheniere Energy burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Cheniere 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. Taking into account all the aforementioned factors, it looks like Cheniere Energy has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given the risks around Cheniere Energy's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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