Indian Oil (NSE:IOC) takes some risk with its use of debt
Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Like many other companies Indian Petroleum Company Limited (NSE:IOC) uses debt. But the more important question is: what risk does this debt create?
Why is debt risky?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. In the worst case, 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 at a low price, thereby permanently diluting shareholders. 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.
Check out our latest analysis for Indian oil
What is Indian Oil’s debt?
You can click on the graph below for historical figures, but it shows that in March 2022, Indian Oil had a debt of ₹1.24t, an increase from ₹1.09t, year on year. On the other hand, he has ₹98.3 billion in cash, resulting in a net debt of around ₹1.14 billion.
A look at Indian Oil’s responsibilities
The latest balance sheet data shows that Indian Oil had liabilities of ₹1.92 billion due within a year, and liabilities of ₹833.4 billion falling due thereafter. In return, he had ₹98.3 billion in cash and ₹191.5 billion in receivables due within 12 months. Thus, its liabilities total ₹2.47t more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on society itself, like a child struggling under the weight of a huge backpack full of books, his sports gear and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Indian Oil would likely need a major recapitalization if it were to pay its creditors today.
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). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Indian Oil has net debt worth 2.4x EBITDA, which isn’t too much, but its interest coverage looks a little low, with EBIT at just 6.6x operating expenses. interests. While that doesn’t worry us too much, it does suggest that interest payments are a bit of a burden. If Indian Oil can continue to grow EBIT at last year’s rate of 15% over last year, then it will find its debt more manageable. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Indian Oil’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Indian Oil has reported free cash flow of 3.3% of its EBIT, which is really quite low. For us, such a low cash conversion creates a bit of paranoia about the ability to extinguish the debt.
Our point of view
We would go so far as to say that Indian Oil’s level of total liabilities was disappointing. But at least it’s decent enough to increase its EBIT; it’s encouraging. Overall, it seems to us that Indian Oil’s balance sheet is really a risk for the company. For this reason, we are quite cautious about the stock and believe shareholders should keep a close eye on its liquidity. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. We have identified 4 warning signs with Indian Oil (at least 2 of which are of concern), and understanding them should be part of your investment process.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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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.