Does Devon Energy (NYSE:DVN) Have A Healthy Balance Sheet?
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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Devon Energy Corporation (NYSE:DVN) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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 think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Devon Energy
What Is Devon Energy's Net Debt?
The chart below, which you can click on for greater detail, shows that Devon Energy had US$6.44b in debt in December 2022; about the same as the year before. However, because it has a cash reserve of US$1.31b, its net debt is less, at about US$5.13b.
How Healthy Is Devon Energy's Balance Sheet?
According to the last reported balance sheet, Devon Energy had liabilities of US$3.11b due within 12 months, and liabilities of US$9.32b due beyond 12 months. Offsetting this, it had US$1.31b in cash and US$1.77b in receivables that were due within 12 months. So its liabilities total US$9.34b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Devon Energy has a huge market capitalization of US$33.1b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). 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).
Devon Energy has a low net debt to EBITDA ratio of only 0.50. And its EBIT easily covers its interest expense, being 24.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Devon Energy grew its EBIT by 142% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Devon Energy's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Devon Energy recorded free cash flow worth 57% 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.
Happily, Devon Energy's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think Devon Energy's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Devon Energy has 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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