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Here's Why TORC Oil & Gas (TSE:TOG) Has A Meaningful Debt Burden

Simply Wall St

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. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies TORC Oil & Gas Ltd. (TSE:TOG) makes use of debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for TORC Oil & Gas

How Much Debt Does TORC Oil & Gas Carry?

You can click the graphic below for the historical numbers, but it shows that TORC Oil & Gas had CA$295.4m of debt in September 2019, down from CA$337.3m, one year before. Net debt is about the same, since the it doesn't have much cash.

TSX:TOG Historical Debt, November 18th 2019

How Strong Is TORC Oil & Gas's Balance Sheet?

The latest balance sheet data shows that TORC Oil & Gas had liabilities of CA$125.9m due within a year, and liabilities of CA$724.5m falling due after that. Offsetting these obligations, it had cash of CA$2.56m as well as receivables valued at CA$49.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$798.6m.

This deficit is considerable relative to its market capitalization of CA$828.1m, so it does suggest shareholders should keep an eye on TORC Oil & Gas's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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.

While TORC Oil & Gas's low debt to EBITDA ratio of 1.0 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.7 last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, TORC Oil & Gas's EBIT fell a jaw-dropping 50% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine TORC Oil & Gas'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 always check how much of that EBIT is translated into free cash flow. Over the last three years, TORC Oil & Gas actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Mulling over TORC Oil & Gas's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that TORC Oil & Gas's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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 editorial-team@simplywallst.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.