Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Above all, Viva Energy Group Limited (ASX: VEA) is in debt. But the more important question is: what risk does this debt create?
When is debt a problem?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, many companies use debt to finance their growth, without any negative consequences. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
See our latest analysis for Viva Energy Group
What is Viva Energy Group’s debt?
The image below, which you can click on for more details, shows that as of December 2021, Viva Energy Group had A$191.9 million in debt, down from A$153.3 million in one year . However, since he has a cash reserve of A$103.5 million, his net debt is less, at around A$88.4 million.
How strong is Viva Energy Group’s balance sheet?
According to the latest published balance sheet, Viva Energy Group had liabilities of A$2.48 billion due within 12 months and liabilities of A$2.72 billion due beyond 12 months. As compensation for these obligations, it had cash of A$103.5 million and receivables valued at A$1.29 billion due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of A$3.80 billion.
This deficit is considerable compared to its market capitalization of 4.40 billion Australian dollars, so it suggests that shareholders monitor the use of debt by Viva Energy Group. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.
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.
Given its net debt to EBITDA ratio of 0.14 and interest coverage of 2.6 times, it seems to us that Viva Energy Group is probably using debt quite sensibly. But the interest payments are certainly enough to make us think about the affordability of its debt. Notably, Viva Energy Group recorded a loss in EBIT last year, but improved it to a positive EBIT of A$485 million in the last twelve months. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Viva Energy Group 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 business needs free cash flow to pay off its debts; book profits are not enough. It is therefore worth checking how much of earnings before interest and tax (EBIT) is supported by free cash flow. In the most recent year, Viva Energy Group recorded free cash flow of 71% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
Viva Energy Group’s net debt to EBITDA was a real benefit in this analysis, as was its conversion of EBIT to free cash flow. However, our confidence was shaken by its apparent struggle to cover its interest costs with its EBIT. When we consider all the factors mentioned above, we feel a bit cautious about Viva Energy Group’s use of debt. While debt has its upside in higher potential returns, we think shareholders should certainly consider how debt levels might make the stock more risky. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, we have identified 1 warning sign for Viva Energy Group of which you should be aware.
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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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.