Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Permian Resources Corporation (NYSE:PR) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Permian Resources
What Is Permian Resources’s Net Debt?
The image below, which you can click on for greater detail, shows that Permian Resources had debt of US$801.8m at the end of June 2022, a reduction from US$1.05b over a year. However, because it has a cash reserve of US$201.1m, its net debt is less, at about US$600.8m.
How Healthy Is Permian Resources’ Balance Sheet?
According to the last reported balance sheet, Permian Resources had liabilities of US$316.1m due within 12 months, and liabilities of US$938.4m due beyond 12 months. Offsetting these obligations, it had cash of US$201.1m as well as receivables valued at US$141.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$911.8m.
Permian Resources has a market capitalization of US$1.96b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense ( its 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).
With net debt sitting at just 0.74 times EBITDA, Permian Resources is arguably pretty conservatively geared. And it boasts interest cover of 8.6 times, which is more than adequate. It was also good to see that despite losing money on the EBIT line last year, Permian Resources turned things around in the last 12 months, delivering and EBIT of US$484m. The balance sheet is clearly the area to focus on when you are analyzing debt. But it is future earnings, more than anything, that will determine Permian Resources’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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Permian Resources produced sturdy free cash flow equating to 77% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Permian Resources’s conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. All these things considered, it appears that Permian Resources can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. When analyzing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Permian Resources is showing 2 warning signs in our investment analysis you should know about…
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
Valuation is complex, but we’re helping make it simple.
Find out whether Permian Resources is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.
View the Free Analysis