Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Origin Energy Limited (ASX:ORG) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Origin Energy's Debt?
The chart below, which you can click on for greater detail, shows that Origin Energy had AU$7.92b in debt in June 2019; about the same as the year before. However, because it has a cash reserve of AU$2.09b, its net debt is less, at about AU$5.82b.
A Look At Origin Energy's Liabilities
According to the last reported balance sheet, Origin Energy had liabilities of AU$4.27b due within 12 months, and liabilities of AU$8.33b due beyond 12 months. Offsetting these obligations, it had cash of AU$2.09b as well as receivables valued at AU$2.32b due within 12 months. So its liabilities total AU$8.18b more than the combination of its cash and short-term receivables.
Origin Energy has a market capitalization of AU$14.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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.
Origin Energy has a rather high debt to EBITDA ratio of 6.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.1 times, suggesting it can responsibly service its obligations. Even worse, Origin Energy saw its EBIT tank 31% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Origin 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Origin Energy actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
To be frank both Origin Energy's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Origin Energy's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. Given our hesitation about the stock, it would be good to know if Origin Energy insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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