Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Matador Resources Company (NYSE:MTDR) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Matador Resources's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Matador Resources had US$1.48b of debt, an increase on US$574.2m, over one year. However, it does have US$60.0m in cash offsetting this, leading to net debt of about US$1.42b.
How Healthy Is Matador Resources's Balance Sheet?
The latest balance sheet data shows that Matador Resources had liabilities of US$336.8m due within a year, and liabilities of US$1.57b falling due after that. On the other hand, it had cash of US$60.0m and US$147.2m worth of receivables due within a year. So its liabilities total US$1.70b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$1.83b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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).
Matador Resources's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 4.9 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It is well worth noting that Matador Resources's EBIT shot up like bamboo after rain, gaining 39% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Matador Resources can strengthen its balance sheet over time. 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, Matador Resources saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Mulling over Matador Resources's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Matador Resources stock 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. 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.
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