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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Magnolia Oil & Gas Corporation (NYSE:MGY) does use debt in its business. But should shareholders be worried about its use of debt?
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. 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. 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.
How Much Debt Does Magnolia Oil & Gas Carry?
As you can see below, Magnolia Oil & Gas had US$387.5m of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$245.0m in cash, and so its net debt is US$142.5m.
How Strong Is Magnolia Oil & Gas’ Balance Sheet?
According to the last reported balance sheet, Magnolia Oil & Gas had liabilities of US$190.7m due within 12 months, and liabilities of US$489.6m due beyond 12 months. Offsetting these obligations, it had cash of US$245.0m as well as receivables valued at US$130.1m due within 12 months. So it has liabilities totalling US$305.1m more than its cash and near-term receivables, combined.
Given Magnolia Oil & Gas has a market capitalization of US$4.42b, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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).
Magnolia Oil & Gas has a low net debt to EBITDA ratio of only 0.12. And its EBIT covers its interest expense a whopping 14.3 times over. So we’re pretty relaxed about its super-conservative use of debt. It was also good to see that despite losing money on the EBIT line last year, Magnolia Oil & Gas turned things around in the last 12 months, delivering and EBIT of US$441m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Magnolia Oil & Gas can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Magnolia Oil & Gas generated free cash flow amounting to a very robust 92% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Happily, Magnolia Oil & Gas’s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Zooming out, Magnolia Oil & Gas seems to use debt quite reasonably; and that gets the nod from us.