David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Geo-Jade Petroleum Corporation (SHSE:600759) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
Check out our latest analysis for Geo-Jade Petroleum
How Much Debt Does Geo-Jade Petroleum Carry?
You can click the graphic below for the historical numbers, but it shows that Geo-Jade Petroleum had CN¥3.48b of debt in June 2023, down from CN¥3.67b, one year before. However, it also had CN¥175.3m in cash, and so its net debt is CN¥3.31b.
A Look At Geo-Jade Petroleum's Liabilities
We can see from the most recent balance sheet that Geo-Jade Petroleum had liabilities of CN¥4.85b falling due within a year, and liabilities of CN¥4.39b due beyond that. On the other hand, it had cash of CN¥175.3m and CN¥272.7m worth of receivables due within a year. So its liabilities total CN¥8.79b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the CN¥5.34b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Geo-Jade Petroleum would probably need a major re-capitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
While Geo-Jade Petroleum's debt to EBITDA ratio (2.8) suggests that it uses some debt, its interest cover is very weak, at 1.5, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. More concerning, Geo-Jade Petroleum saw its EBIT drop by 2.0% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Geo-Jade Petroleum will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Geo-Jade Petroleum recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
On the face of it, Geo-Jade Petroleum's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, we think it's fair to say that Geo-Jade Petroleum has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Geo-Jade Petroleum has 1 warning sign we think you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an 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 account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.