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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 can see that Cardinal Energy Ltd. (TSE:CJ) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Cardinal Energy
What Is Cardinal Energy's Debt?
As you can see below, Cardinal Energy had CA$239.2m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has CA$4.91m in cash leading to net debt of about CA$234.3m.
How Healthy Is Cardinal Energy's Balance Sheet?
The latest balance sheet data shows that Cardinal Energy had liabilities of CA$64.8m due within a year, and liabilities of CA$362.5m falling due after that. On the other hand, it had cash of CA$4.91m and CA$41.0m worth of receivables due within a year. So its liabilities total CA$381.4m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of CA$295.0m, we think shareholders really should watch Cardinal Energy's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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).