The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Public Joint Stock Company Gazprom (MCX:GAZP) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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 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. 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.
What Is Gazprom's Net Debt?
As you can see below, at the end of June 2019, Gazprom had ₽3.71t of debt, up from ₽3.37t a year ago. Click the image for more detail. However, it also had ₽1.69t in cash, and so its net debt is ₽2.02t.
How Healthy Is Gazprom's Balance Sheet?
According to the last reported balance sheet, Gazprom had liabilities of ₽2.45t due within 12 months, and liabilities of ₽4.75t due beyond 12 months. On the other hand, it had cash of ₽1.69t and ₽978.9b worth of receivables due within a year. So its liabilities total ₽4.53t more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of ₽5.45t, so it does suggest shareholders should keep an eye on Gazprom's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
Gazprom has a low debt to EBITDA ratio of only 0.75. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. In addition to that, we're happy to report that Gazprom has boosted its EBIT by 63%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Gazprom's ability to maintain a healthy balance sheet going forward. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Gazprom 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.
Gazprom's interest cover was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to convert EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Gazprom's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Gazprom's dividend history, without delay!
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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