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. We can see that ConocoPhillips (NYSE:COP) does use debt in its business. 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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does ConocoPhillips Carry?
As you can see below, ConocoPhillips had US$14.2b of debt at June 2019, down from US$15.0b a year prior. However, it also had US$8.51b in cash, and so its net debt is US$5.67b.
A Look At ConocoPhillips's Liabilities
The latest balance sheet data shows that ConocoPhillips had liabilities of US$9.00b due within a year, and liabilities of US$29.2b falling due after that. Offsetting these obligations, it had cash of US$8.51b as well as receivables valued at US$3.65b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$26.0b.
While this might seem like a lot, it is not so bad since ConocoPhillips has a huge market capitalization of US$59.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
ConocoPhillips has a low net debt to EBITDA ratio of only 0.36. And its EBIT easily covers its interest expense, being 13.9 times the size. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that ConocoPhillips has boosted its EBIT by 45%, thus reducing the spectre of future debt repayments. 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 ConocoPhillips 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 we always check how much of that EBIT is translated into free cash flow. Over the most recent two years, ConocoPhillips recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that ConocoPhillips's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. Taking all this data into account, it seems to us that ConocoPhillips takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. Over time, share prices tend to follow earnings per share, so if you're interested in ConocoPhillips, 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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