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 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 Panhandle Oil and Gas Inc. (NYSE:PHX) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Panhandle Oil and Gas's Debt?
As you can see below, Panhandle Oil and Gas had US$41.5m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$1.53m, its net debt is less, at about US$40.0m.
How Strong Is Panhandle Oil and Gas's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Panhandle Oil and Gas had liabilities of US$2.44m due within 12 months and liabilities of US$67.7m due beyond that. On the other hand, it had cash of US$1.53m and US$6.01m worth of receivables due within a year. So it has liabilities totalling US$62.6m more than its cash and near-term receivables, combined.
Panhandle Oil and Gas has a market capitalization of US$187.8m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
Panhandle Oil and Gas's net debt is sitting at a very reasonable 1.5 times its EBITDA, while its EBIT covered its interest expense just 5.0 times last year. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. Pleasingly, Panhandle Oil and Gas is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 129% gain in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Panhandle Oil and Gas 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Panhandle Oil and Gas recorded free cash flow of 37% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On our analysis Panhandle Oil and Gas's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. When we consider all the elements mentioned above, it seems to us that Panhandle Oil and Gas is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. We'd be motivated to research the stock further if we found out that Panhandle Oil and Gas insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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