Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, CONSOL Energy Inc. (NYSE:CEIX) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does CONSOL Energy Carry?
You can click the graphic below for the historical numbers, but it shows that CONSOL Energy had US$418.1m of debt in September 2022, down from US$625.3m, one year before. However, because it has a cash reserve of US$268.9m, its net debt is less, at about US$149.2m.
How Healthy Is CONSOL Energy’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that CONSOL Energy had liabilities of US$515.0m due within 12 months and liabilities of US$1.29b due beyond that. On the other hand, it had cash of US$268.9m and US$147.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.39b.
This deficit is considerable relative to its market capitalization of US$2.19b, so it does suggest shareholders should keep an eye on CONSOL Energy’s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
CONSOL Energy has net debt of just 0.21 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 9.8 times the interest expense over the last year. It was also good to see that despite losing money on the EBIT line last year, CONSOL Energy turned things around in the last 12 months, delivering and EBIT of US$491m. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if CONSOL Energy can strengthen its balance sheet over time.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the most recent year, CONSOL Energy recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
The good news is that CONSOL Energy’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. All these things considered, it appears that CONSOL Energy can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one.