Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. Mostly, Bharat Petroleum Corporation Limited (NSE: BPCL) is indebted. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. If things go really bad, lenders can take over the business. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for Bharat Petroleum
What is Bharat Petroleum’s debt?
The image below, which you can click on for more details, shows that as of September 2021, Bharat Petroleum had a debt of ₹582.8 billion, up from ₹492.7 billion in a year. However, he has ₹170.5 billion in cash to offset this, resulting in a net debt of around ₹412.3 billion.
A Look at Bharat Petroleum’s Responsibilities
According to the latest published balance sheet, Bharat Petroleum had liabilities of ₹842.4 billion due within 12 months and liabilities of ₹541.6 billion due beyond 12 months. As compensation for these obligations, it had cash of ₹170.5 billion as well as receivables valued at ₹73.7 billion due within 12 months. Thus, his liabilities outweigh the sum of his cash and (short-term) receivables by ₹1.14t.
When you consider that this shortfall exceeds the company’s huge ₹781.6 billion market capitalization, you might well be inclined to take a close look at the balance sheet. In theory, extremely large dilution would be required if the company were forced to repay its debts by raising capital at the current share price.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
With a debt to EBITDA ratio of 2.1, Bharat Petroleum uses debt wisely but responsibly. And the attractive interest cover (EBIT of 9.9 times interest expense) certainly makes do not do everything to dispel this impression. We note that Bharat Petroleum has increased its EBIT by 27% over the past year, which should facilitate debt repayment in the future. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Bharat Petroleum can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a company can only repay its debts with cash, not book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Bharat Petroleum has recorded free cash flow of 45% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.
Our point of view
While the level of Bharat Petroleum’s total liabilities makes us nervous. The EBIT growth rate and interest coverage were encouraging signs. When we consider all the factors mentioned, it seems to us that Bharat Petroleum is taking risks with its use of debt. While this debt may increase returns, we believe the company now has sufficient leverage. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, Bharat Petroleum has 4 warning signs (and 1 of concern) that we think you should know about.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.