The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Centennial Resource Development, Inc. (NASDAQ:CDEV) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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.
What Is Centennial Resource Development's Net Debt?
The image below, which you can click on for greater detail, shows that Centennial Resource Development had debt of US$801.2m at the end of March 2022, a reduction from US$1.06b over a year. However, it also had US$50.6m in cash, and so its net debt is US$750.6m.
How Healthy Is Centennial Resource Development's Balance Sheet?
The latest balance sheet data shows that Centennial Resource Development had liabilities of US$299.7m due within a year, and liabilities of US$887.7m falling due after that. On the other hand, it had cash of US$50.6m and US$131.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.00b.
While this might seem like a lot, it is not so bad since Centennial Resource Development has a market capitalization of US$1.88b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
While Centennial Resource Development's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.1 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We also note that Centennial Resource Development improved its EBIT from a last year's loss to a positive US$236m. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Centennial Resource Development's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Centennial Resource Development actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Our View
When it comes to the balance sheet, the standout positive for Centennial Resource Development was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For example, its interest cover makes us a little nervous about its debt. Considering this range of data points, we think Centennial Resource Development is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. To that end, you should be aware of the 1 warning sign we've spotted with Centennial Resource Development .
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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