Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 can see that National Fuel Gas Company (NYSE:NFG) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does National Fuel Gas Carry?
As you can see below, at the end of June 2022, National Fuel Gas had US$3.03b of debt, up from US$2.63b a year ago. Click the image for more detail. On the flip side, it has US$432.6m in cash leading to net debt of about US$2.60b.
A Look At National Fuel Gas' Liabilities
The latest balance sheet data shows that National Fuel Gas had liabilities of US$2.17b due within a year, and liabilities of US$3.94b falling due after that. On the other hand, it had cash of US$432.6m and US$417.6m worth of receivables due within a year. So its liabilities total US$5.26b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of US$6.51b, so it does suggest shareholders should keep an eye on National Fuel Gas' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
National Fuel Gas's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 5.8 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We note that National Fuel Gas grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if National Fuel Gas can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, National Fuel Gas burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
National Fuel Gas's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its EBIT growth rate was refreshing. We should also note that Gas Utilities industry companies like National Fuel Gas commonly do use debt without problems. Taking the abovementioned factors together we do think National Fuel Gas's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 3 warning signs with National Fuel Gas , and understanding them should be part of your investment process.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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