Warren Buffett said: “Volatility is far from synonymous with risk”. It’s only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. We can see that Birchcliff Energy Ltd. (TSE: BIR) uses debt in its business. But the real question is whether this debt makes the business risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that he must raise new equity at low cost, thereby diluting shareholders over the long term. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is Birchcliff Energy’s net debt?
You can click on the graph below for historical figures, but it shows Birchcliff Energy had C $ 759.2 million in debt in June 2021, up from C $ 802.2 million a year earlier. Net debt is about the same because it doesn’t have a lot of cash.
How strong is Birchcliff Energy’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Birchcliff Energy had a liability of C $ 222.8 million due within 12 months and a liability of C $ 1.08 billion beyond. In return, he had C $ 17,000 in cash and C $ 80.7 million in receivables due within 12 months. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by C $ 1.22 billion.
This is a mountain of leverage compared to its market capitalization of C $ 1.76 billion. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Birchcliff Energy has net debt of 2.1 times EBITDA, which isn’t too much, but its interest coverage looks a bit weak, with EBIT at just 4.5 times interest expense. It appears the company incurs significant depreciation and amortization costs, so perhaps its debt load is heavier than it first appears, since EBITDA is arguably a generous measure of profits. Notably, Birchcliff Energy recorded a loss in EBIT level last year, but improved it to a positive EBIT of C $ 148 million in the last twelve months. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Birchcliff Energy can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business can only repay its debts with hard cash, not with book profits. It is therefore worth checking to what extent earnings before interest and taxes (EBIT) are backed by free cash flow. In the most recent year, Birchcliff Energy recorded free cash flow of 25% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.
Our point of view
While Birchcliff Energy’s level of total liabilities makes us cautious about this, its track record of converting EBIT to free cash flow is no better. But it’s not so bad to (not) increase your EBIT. When we consider all the factors discussed, it seems to us that Birchcliff Energy is taking risks with its recourse to 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 off the balance sheet. For example – Birchcliff Energy has 3 warning signs we think you should be aware.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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