Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. We notice that Oil refineries Ltd. (TLV: ORL) has a debt on its balance sheet. But should shareholders be concerned about its use of debt?
When is debt dangerous?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
Check out our latest analysis for petroleum refineries
What is the debt of oil refineries?
You can click on the graph below for historical figures, but it shows that as of September 2021, oil refineries had debt of US $ 1.68 billion, an increase from US $ 1.54 billion. US dollars, over one year. However, he also had $ 727.8 million in cash, so his net debt is $ 954.5 million.
How strong is the balance sheet of petroleum refineries?
Zooming in on the latest balance sheet data, we can see that oil refineries had US $ 1.28 billion liabilities due within 12 months and US $ 1.65 billion liabilities due beyond. . On the other hand, it had $ 727.8 million in cash and $ 494.9 million in receivables due within one year. It therefore has liabilities totaling US $ 1.70 billion more than its cash and short-term receivables combined.
This deficit casts a shadow over the $ 960.3 million company as a towering colossus of mere mortals. We therefore believe that shareholders should monitor it closely. Ultimately, oil refineries would likely need a major recapitalization if their creditors demanded repayment.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). Thus, we look at debt versus earnings with and without amortization expenses.
Oil refinery net debt stands at a very reasonable level of 2.3 times its EBITDA, while its EBIT only covered interest expense 2.5 times last year. While we’re not worried about these numbers, it’s worth noting that the cost of the company’s debt does have a real impact. Notably, petroleum refineries recorded a loss in EBIT level last year, but improved it to a positive EBIT of US $ 255 million in the past twelve months. The balance sheet is clearly the area to focus on when analyzing debt. But you can’t look at debt in isolation; since oil refineries will need revenue to pay off this debt. So if you want to know more about its profits, it may be worth checking out this long term profit trend chart.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. It is therefore important to check to what extent its earnings before interest and taxes (EBIT) are converted into actual free cash flow. In the most recent year, petroleum refineries recorded free cash flow of 37% of their EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.
Our point of view
We would go so far as to say that the level of total liabilities of petroleum refineries was disappointing. That said, his ability to increase his EBIT is not that much of a concern. We’re pretty clear that we consider oil refineries to be really pretty risky, because of the health of their balance sheets. For this reason, we are fairly cautious about the stock, and we believe shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. Concrete example: we have spotted 2 warning signs for oil refineries you must 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.
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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 any stock 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.