Legendary fund manager Li Lu (backed by Charlie Munger) once said: ‘The biggest investment risk is not price volatility, but whether you will suffer a permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when considering how risky it is, as debt is often involved when a company fails. We find that Chennai Petroleum Corporation Limited (NSE:CHENNPETRO) has debt on its balance sheet. But the real question is whether this debt makes the company risky.
Why does debt bring risk?
In general, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or using its own cash flow. Ultimately, if the company is unable to meet its legal obligations to repay the debt, shareholders may walk away with nothing. However, a more common (but still expensive) situation is when a company has to reduce shareholder equity at a low share price simply to manage debt. Of course, debt can be an important tool in businesses, especially capital-heavy businesses. When considering the use of debt in a business, we first look at cash and debt together.
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How Much Debt Does Chennai Petroleum Have?
For historical numbers, you can click on the graphic below, which shows that Chennai Petroleum had ₹74.7 billion in debt as of September 2022, down from ₹104.6 billion a year earlier. Net debt is about the same since he doesn’t have much money.
How strong is Chennai Petroleum’s balance sheet?
The latest balance sheet figures show that Chennai Petroleum had liabilities of ₹127.9 billion due within a year, liabilities of ₹33.6 billion due beyond that year. On the other hand, it had cash of ₹83.8 crore and ₹13.2 billion in receivables due within a year. So it has liabilities totaling INR 148.2 billion more than its cash and current receivables combined.
The shortage here weighs heavily on the ₹32.1 billion company itself, like a child struggling under the weight of a huge backpack full of books, his sports equipment and a trumpet. Therefore, we definitely think that shareholders should keep a close eye on this. After all, Chennai Petroleum would probably need a bigger recapitalization if its creditors demanded repayment.
We measure a company’s leverage against its earnings power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and by calculating how quickly its earnings before interest and taxes (EBIT) covers its interest expense (interest coverage). Thus, we consider debt to profit both with and without depreciation.
Chennai Petroleum’s net debt is just 1.2 times its EBITDA. And its EBIT covers interest costs by a whopping 17.7 times. So we’re pretty relaxed about his super-conservative use of debt. Even more impressive was the fact that Chennai Petroleum grew its EBIT by 540% in twelve months. If this growth is maintained, the debt will be even more manageable in the coming years. When analyzing debt levels, the balance sheet is an obvious place to start. But Chennai Petroleum’s profit will affect the balance sheet going forward. So when thinking about debt, it’s definitely worth looking at the earnings trend. Click here for an interactive clip.
But our last consideration is just as important, for a company cannot pay its debt with paper profits; he needs cold hard cash. So we always check how much of that EBIT translates into free cash flow. Looking at the last two years, Chennai Petroleum recorded free cash flow of 31% of its EBIT, which is less than we expected. This is not good when it comes to paying off debt.
Our view
While Chennai Petroleum’s level of total liabilities is making us nervous. For example, its interest coverage and EBIT growth rate give us some confidence in its ability to manage its debt. Taking the above-mentioned factors together, we believe that Chennai Petroleum’s debt poses some risk to the company. So, while this leverage increases ROE, we don’t want it to increase from here on out. The balance sheet is an obvious area to focus on when analyzing debt. Not all investment risk is on the balance sheet – far from it. Example: We noticed 2 warning signs for Chennai Petroleum you must be aware.
Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net money growth stocks today.
Valuation is complex, but we help simplify it.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or financial situation. Our goal is to provide long-term oriented analysis based on fundamental data. Please note that our analysis may not take into account recent price sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.