Some say that volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett once said that “volatility is far from synonymous with risk.” It seems the smart money knows that debt – which usually comes with bankruptcies – is a very important factor when you assess how risky a company is. We note that Bonanza Creek Energy, Inc. (NYSE:BCEI) has debts on its balance sheet. But should shareholders be concerned about using debt?
When is debt dangerous?
Debt and other obligations become risky for a company when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An essential part of capitalism is the process of ‘creative destruction’, in which failed companies are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it needs to raise new equity at a low price, permanently diluting shareholders. That said, the most common situation is for a company to manage its debt fairly well — and for its own benefit. When we think about a company’s use of debt, let’s first look at cash and debt together.
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What is Bonanza Creek Energy’s Net Debt?
You can click on the image below for the historical numbers, but it shows Bonanza Creek Energy had debt of US$199.0 million in June 2021, up from US$58.0 million, over a year. However, because it has a cash reserve of $24.4 million, its net debt is less, at approximately $174.6 million.
A Look at Bonanza Creek Energy’s Commitments
If we zoom in on the most recent balance sheet data, we can see that Bonanza Creek Energy had debts of US$230.4 million that were due within 12 months and liabilities of US$300.7 million that were due after that. On the other hand, the company had $24.4 million in cash and $97.6 million in receivables due within a year. Thus, his liabilities total US$409.0 million more than the combination of his cash and receivables.
While this may seem like a lot, it’s not a big deal since Bonanza Creek Energy has a market cap of US$1.13 billion, so it could probably bolster its balance sheet by raising capital if needed. But we definitely want to keep our eyes peeled for evidence that his debt carries too much risk.
To upgrade a company’s debt relative to revenue, we calculate net debt divided by revenue before interest, taxes, depreciation, and amortization (EBITDA) and revenue before interest and tax (EBIT) divided by interest expense (are interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with the interest coverage ratio).
While Bonanza Creek Energy’s low debt-to-EBITDA ratio of 1.4 suggests only modest use of debt, the fact that last year’s EBIT only covered interest charges 3.6 times gives us pause. We therefore recommend keeping a close eye on the impact of financing costs on the business. Importantly, Bonanza Creek Energy’s EBIT fell by a whopping 79% over the past twelve months. If that decline continues, paying off debt will be more difficult than selling foie gras at a vegan convention. When analyzing debt levels, the balance sheet is the obvious place to start. Ultimately, though, the company’s future profitability will decide whether Bonanza Creek Energy can strengthen its balance sheet over time. So if you want to see what the pros think, you might find this free analyst earnings forecast report be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard money. So we always look at how much of that EBIT is translated into free cash flow. Over the past three years, Bonanza Creek Energy has recorded an overall cash outflow. Debt is much more risky for companies with unreliable free cash flow, so shareholders should hope that past spending will yield free cash flow in the future.
To be fair, both Bonanza Creek Energy’s conversion from EBIT to free cash flow and its track record of (not) growing its EBIT make us quite uncomfortable with its debt levels. But at least it’s pretty good at managing its debt, based on its EBITDA; that’s encouraging. Looking at the bigger picture, it seems clear to us that Bonanza Creek Energy’s use of debt carries risks for the company. If all goes well, that can pay off, but the downside of this debt is a greater risk of lasting losses. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside within the balance sheet – far from it. For example, we have established: 6 Warning Signs for Bonanza Creek Energy that you should be aware of.
Are you more interested in a fast-growing company with a strong balance sheet, then take a look our list of net cash growth stocks without delay.
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