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. As with many other companies Lundin Petroleum AB (publ) (STO:LUPE) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for Lundin Petroleum
What Is Lundin Petroleum's Net Debt?
The image below, which you can click on for greater detail, shows that Lundin Petroleum had debt of US$3.28b at the end of June 2019, a reduction from US$3.65b over a year. On the flip side, it has US$107.6m in cash leading to net debt of about US$3.18b.
A Look At Lundin Petroleum's Liabilities
We can see from the most recent balance sheet that Lundin Petroleum had liabilities of US$790.0m falling due within a year, and liabilities of US$6.40b due beyond that. On the other hand, it had cash of US$107.6m and US$169.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$6.91b.
This is a mountain of leverage even relative to its gargantuan market capitalization of US$10.0b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).