Is Paramount Resources (TSE:POU) using too much debt?

Warren Buffett said: “Volatility is far from synonymous with risk. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Like many other companies Paramount Resources Ltd. (TSE:POU) uses debt. But the more important question is: what risk does this debt create?

When is debt dangerous?

Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. If things go really bad, lenders can take over the business. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. 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. 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 Paramount Resources

How much debt does Paramount Resources have?

You can click on the chart below for historical numbers, but it shows Paramount Resources had C$395.9 million in debt in December 2021, up from C$842.5 million a year prior. Net debt is about the same, since she doesn’t have a lot of cash.

TSX:POU Debt to Equity May 1, 2022

How healthy is Paramount Resources’ balance sheet?

We can see from the most recent balance sheet that Paramount Resources had liabilities of C$256.0 million maturing within one year, and liabilities of C$1.02 billion due beyond. On the other hand, it had cash of C$1.70 million and C$141.9 million of receivables due within one year. Thus, its liabilities total C$1.14 billion more than the combination of its cash and short-term receivables.

Paramount Resources has a market capitalization of C$4.38 billion, so it could very likely raise funds to improve its balance sheet, should the need arise. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without amortization and depreciation expense.

With net debt of just 0.96 times EBITDA, Paramount Resources is arguably quite conservative. And this view is supported by strong interest coverage, with EBIT amounting to 7.1 times interest expense over the past year. What is even more impressive is that Paramount Resources increased its EBIT by 450% year-over-year. This boost will make it even easier to pay off debt in the future. 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 Paramount Resources’ 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.

Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past two years, Paramount Resources has reported free cash flow of 17% 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

Paramount Resources’ EBIT growth rate suggests it can manage its debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. But, on a darker note, we are a bit concerned about its conversion of EBIT into free cash flow. Looking at all of the aforementioned factors together, it seems to us that Paramount Resources can manage its debt quite comfortably. Of course, while this leverage can improve return on equity, it comes with more risk, so it’s worth keeping an eye out for. 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 outside of the balance sheet. Be aware that Paramount Resources displays 5 warning signs in our investment analysis and 1 of them does not suit us too much…

Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.

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.

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