David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Diamondback Energy, Inc. (NASDAQ:FANG) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Diamondback Energy Carry?
As you can see below, at the end of June 2023, Diamondback Energy had US$6.74b of debt, up from US$5.60b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn’t have much cash.
How Healthy Is Diamondback Energy’s Balance Sheet?
We can see from the most recent balance sheet that Diamondback Energy had liabilities of US$2.12b falling due within a year, and liabilities of US$9.25b due beyond that. Offsetting these obligations, it had cash of US$18.0m as well as receivables valued at US$807.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$10.6b.
This deficit isn’t so bad because Diamondback Energy is worth a massive US$32.9b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
Diamondback Energy has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 18.6 times over. So we’re pretty relaxed about its super-conservative use of debt. But the other side of the story is that Diamondback Energy saw its EBIT decline by 9.3% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Diamondback Energy’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Diamondback Energy’s free cash flow amounted to 49% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
Our View
When it comes to the balance sheet, the standout positive for Diamondback Energy was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren’t so heartening. For example, its EBIT growth rate makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Diamondback Energy’s use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet.