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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Beach Energy Limited (ASX:BPT) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.
What Is Beach Energy's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 Beach Energy had AU$56.7m of debt, an increase on none, over one year. But on the other hand it also has AU$109.9m in cash, leading to a AU$53.2m net cash position.
How Healthy Is Beach Energy's Balance Sheet?
The latest balance sheet data shows that Beach Energy had liabilities of AU$456.2m due within a year, and liabilities of AU$939.2m falling due after that. On the other hand, it had cash of AU$109.9m and AU$231.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$1.05b.
While this might seem like a lot, it is not so bad since Beach Energy has a market capitalization of AU$2.62b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Beach Energy also has more cash than debt, so we're pretty confident it can manage its debt safely.
But the bad news is that Beach Energy has seen its EBIT plunge 16% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Beach 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Beach Energy has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Beach Energy's free cash flow amounted to 47% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Although Beach Energy's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$53.2m. So we are not troubled with Beach Energy's debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for Beach Energy (2 are significant!) that you should be aware of before investing here.
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.
This article by Simply Wall St is general in nature. 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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