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.' 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 Jagged Peak Energy Inc. (NYSE:JAG) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Jagged Peak Energy's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Jagged Peak Energy had US$639.9m of debt, an increase on US$488.9m, over one year. However, it does have US$24.8m in cash offsetting this, leading to net debt of about US$615.1m.
How Healthy Is Jagged Peak Energy's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Jagged Peak Energy had liabilities of US$226.8m due within 12 months and liabilities of US$786.3m due beyond that. On the other hand, it had cash of US$24.8m and US$59.9m worth of receivables due within a year. So its liabilities total US$928.4m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of US$1.39b, so it does suggest shareholders should keep an eye on Jagged Peak Energy's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
Looking at its net debt to EBITDA of 1.4 and interest cover of 4.9 times, it seems to us that Jagged Peak Energy is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Notably, Jagged Peak Energy made a loss at the EBIT level, last year, but improved that to positive EBIT of US$168m in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Jagged Peak Energy's ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Jagged Peak Energy burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Mulling over Jagged Peak Energy's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. Overall, we think it's fair to say that Jagged Peak Energy has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 Jagged Peak Energy's earnings per share history for free.
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.
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