Origin Energy (ASX:ORG) seems to be using debt quite wisely
Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” 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. Mostly, Limited original energy (ASX:ORG) is in debt. But the more important question is: what risk does this debt create?
When is debt dangerous?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. 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, debt can be an important tool in businesses, especially capital-intensive businesses. When we think about a company’s use of debt, we first look at cash and debt together.
See our latest analysis for Origin Energy
What is Origin Energy’s debt?
The image below, which you can click on for more details, shows that as of December 2021, Origin Energy had A$5.29 billion in debt, up from A$4.76 billion in one year. However, he has A$214.0 million in cash to offset this, resulting in a net debt of around A$5.08 billion.
A look at Origin Energy’s passives
According to the latest published balance sheet, Origin Energy had liabilities of A$3.96 billion due within 12 months and liabilities of A$8.24 billion due beyond 12 months. On the other hand, it had cash of A$214.0 million and A$2.01 billion of receivables due within one year. Thus, its liabilities total A$9.97 billion more than the combination of its cash and short-term receivables.
That shortfall is sizable relative to its A$10.8 billion market capitalization, so he suggests shareholders watch Origin Energy’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
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). 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 ).
Low interest coverage of 1.3x and an extremely high net debt to EBITDA ratio of 15.5 shook our confidence in Origin Energy like a punch in the gut. The debt burden here is considerable. The silver lining is that Origin Energy grew its EBIT by 1,833% last year, which feeds like youthful idealism. If he can keep walking on this path, he will be able to get rid of his debt with relative ease. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Origin Energy can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a company can only repay its debts with cold hard cash, not with book profits. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Fortunately for all shareholders, Origin Energy has actually produced more free cash flow than EBIT for the past three years. There’s nothing better than incoming money to stay in the good books of your lenders.
Our point of view
Origin Energy’s interest coverage was a real negative in this analysis, as was its net debt to EBITDA. But like a ballerina finishing on a perfect pirouette, she has no trouble converting EBIT into free cash flow. It should also be noted that Origin Energy belongs to the electric utility sector, which is often considered quite defensive. When we consider all the factors mentioned above, we feel a bit cautious about Origin Energy’s use of debt. While debt has its upside in higher potential returns, we think shareholders should certainly consider how debt levels might make the stock more risky. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. To this end, you should be aware of the 2 warning signs we spotted with Origin Energy.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
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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.