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. Importantly, Oil and Natural Gas Corporation Limited (NSE:ONGC) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. 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. 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 examine debt levels, we first consider both cash and debt levels, together.
View our latest analysis for Oil and Natural Gas
What Is Oil and Natural Gas’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2022 Oil and Natural Gas had ₹1.43t of debt, an increase on ₹1.09t, over one year. On the flip side, it has ₹365.4b in cash leading to net debt of about ₹1.06t.
A Look At Oil and Natural Gas’ Liabilities
We can see from the most recent balance sheet that Oil and Natural Gas had liabilities of ₹1.41t falling due within a year, and liabilities of ₹1.90t due beyond that. Offsetting this, it had ₹365.4b in cash and ₹174.7b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹2.77t.
When you consider that this deficiency exceeds the company’s huge ₹1.86t market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
Oil and Natural Gas has net debt of just 1.3 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it’s fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. In addition to that, we’re happy to report that Oil and Natural Gas has boosted its EBIT by 72%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Oil and Natural Gas can strengthen its balance sheet over time. 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 that EBIT is backed by free cash flow. Looking at the most recent three years, Oil and Natural Gas recorded free cash flow of 44% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
While Oil and Natural Gas’s level of total liabilities has us nervous. To wit both its interest cover and EBIT growth rate were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Oil and Natural Gas is a somewhat risky investment as a result of its debt. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. These risks can be hard to spot. Every…
Read More: Oil and Natural Gas (NSE:ONGC) Has A Somewhat Strained Balance Sheet