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Is OceanaGold (TSE:OGC) Using Too Much Debt?

Simply Wall St

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.' 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 OceanaGold Corporation (TSE:OGC) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for OceanaGold

What Is OceanaGold's Net Debt?

You can click the graphic below for the historical numbers, but it shows that OceanaGold had US$150.0m of debt in June 2019, down from US$232.9m, one year before. On the flip side, it has US$84.7m in cash leading to net debt of about US$65.3m.

TSX:OGC Historical Debt, September 2nd 2019

How Strong Is OceanaGold's Balance Sheet?

The latest balance sheet data shows that OceanaGold had liabilities of US$190.6m due within a year, and liabilities of US$278.1m falling due after that. Offsetting these obligations, it had cash of US$84.7m as well as receivables valued at US$18.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$365.7m.

This deficit isn't so bad because OceanaGold is worth US$1.49b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

OceanaGold has net debt of just 0.23 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 7.7 times the interest expense over the last year. It is just as well that OceanaGold's load is not too heavy, because its EBIT was down 52% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if OceanaGold 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, OceanaGold created free cash flow amounting to 15% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

OceanaGold's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability handle its debt, based on its EBITDA, isn't too shabby at all. Taking the abovementioned factors together we do think OceanaGold's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Given our hesitation about the stock, it would be good to know if OceanaGold insiders have sold any shares recently. You click here to find out if insiders have sold recently.

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.

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.