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, Cimarex Energy Co. (NYSE:XEC) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Cimarex Energy's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Cimarex Energy had US$1.98b of debt, an increase on US$1.49b, over one year. Net debt is about the same, since the it doesn't have much cash.
How Healthy Is Cimarex Energy's Balance Sheet?
According to the last reported balance sheet, Cimarex Energy had liabilities of US$814.7m due within 12 months, and liabilities of US$2.84b due beyond 12 months. Offsetting these obligations, it had cash of US$19.4m as well as receivables valued at US$387.4m due within 12 months. So it has liabilities totalling US$3.25b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of US$5.07b, so it does suggest shareholders should keep an eye on Cimarex Energy's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Cimarex Energy's net debt is only 1.3 times its EBITDA. And its EBIT easily covers its interest expense, being 25.4 times the size. So we're pretty relaxed about its super-conservative use of debt. Fortunately, Cimarex Energy grew its EBIT by 3.4% in the last year, making that debt load look even more manageable. 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 Cimarex 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Cimarex Energy actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
Cimarex Energy's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Cimarex Energy'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 Cimarex Energy, 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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