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. We can see that Horizon Oil Limited (ASX:HZN) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Horizon Oil Carry?
The image below, which you can click on for greater detail, shows that Horizon Oil had debt of US$82.7m at the end of December 2018, a reduction from US$120.0m over a year. On the flip side, it has US$20.4m in cash leading to net debt of about US$62.4m.
How Strong Is Horizon Oil's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Horizon Oil had liabilities of US$57.0m due within 12 months and liabilities of US$106.4m due beyond that. On the other hand, it had cash of US$20.4m and US$14.5m worth of receivables due within a year. So its liabilities total US$128.6m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's US$104.2m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
While Horizon Oil's low debt to EBITDA ratio of 0.77 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.5 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Pleasingly, Horizon Oil is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 115% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Horizon Oil will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last two years, Horizon Oil generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Horizon Oil's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. But truth be told its level of total liabilities had us nibbling our nails. When we consider all the elements mentioned above, it seems to us that Horizon Oil is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Horizon Oil's earnings per share history for free.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.