Legendary fund manager Li Lu (who Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Like many other companies Diamondback Energy, Inc. (NASDAQ: FANG) uses debt. But the real question is whether this debt makes the business risky.
What risk does debt entail?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is Diamondback Energy’s debt?
You can click on the graph below for historical figures, but it shows that as of June 2021, Diamondback Energy had a debt of $ 7.38 billion, an increase from $ 5.95 billion. , over one year. On the other hand, it has $ 344.0 million in cash, resulting in net debt of around $ 7.03 billion.
How strong is Diamondback Energy’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Diamondback Energy had a liability of US $ 1.97 billion owed within 12 months and a liability of US $ 8.47 billion owed beyond that. In compensation for these obligations, it had cash of US $ 344.0 million as well as receivables valued at US $ 690.0 million within 12 months. Its liabilities therefore total $ 9.41 billion more than the combination of its cash and short-term receivables.
While that might sound like a lot, it’s not that bad since Diamondback Energy has a massive market cap of US $ 16.1 billion, and could therefore likely strengthen its balance sheet by raising capital if needed. But we absolutely want to keep our eyes open for indications that its debt is too risky.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Diamondback Energy’s net debt is 3.3 times its EBITDA, which is significant but still reasonable leverage. But its EBIT was around 59.4 times its interest expense, implying that the company isn’t really paying a high cost to maintain that level of debt. Even if the low cost turned out to be unsustainable, that’s a good sign. Unfortunately, Diamondback Energy’s EBIT has fallen 17% over the past four quarters. If incomes continue to drop at this rate, it will be more difficult to manage debt than taking three kids under 5 to a fancy pants restaurant. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Diamondback Energy can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, Diamondback Energy has experienced substantial total negative free cash flow. While investors no doubt expect this situation to reverse in due course, it clearly means that its use of debt is riskier.
Our point of view
To be frank, Diamondback Energy’s EBIT growth rate and track record of converting EBIT to free cash flow makes us rather uncomfortable with its leverage levels. But at least it’s decent enough to cover its interest costs with its EBIT; it’s encouraging. Overall, we think it’s fair to say that Diamondback Energy has enough debt that there is real risk around the balance sheet. If all goes well, this should increase returns, but on the other hand, the risk of permanent capital loss is increased by debt. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. For example – Diamondback Energy has 2 warning signs we think you should be aware.
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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