David Iben put it well when he said, “Volatility is not a risk we care about. What we care about is preventing permanent loss of capital.’ It is only natural to consider a company’s balance sheet when considering how risky it is, as there are often debts when a company collapses. We can see that Diamondback Energy, Inc. (NASDAQ:FANG) does use debt in its business. But should shareholders be concerned about using debt?
When is debt dangerous?
Debt and other obligations become risky for a company when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An essential part of capitalism is the process of ‘creative destruction’, in which failed companies are mercilessly liquidated by their bankers. However, a more frequent (but still costly) event is a company having to issue shares at spot prices, permanently diluting shareholders, just to bolster its balance sheet. However, by replacing dilution, debt can be an extremely good tool for companies that need capital to invest in high-yield growth. When we think about a company’s use of debt, let’s first look at cash and debt together.
🎬📺 Free Movies and Free TV Shows! 🎭🎬
What is Diamondback Energy’s net debt?
The image below, which you can click on for more details, shows Diamondback Energy had debt of US$7.65 billion in March 2021, up from US$5.68 billion in one year. Net debt is about the same as it doesn’t have a lot of cash.
How healthy is Diamondback Energy’s balance sheet?
The most recent balance sheet data shows that Diamondback Energy had liabilities of $1.87 billion that were due within one year, and that liabilities of $8.48 billion were due after that. On the other hand, it had $121.0 million in cash and $632.0 million in receivables due within a year. So it has liabilities totaling $9.59 billion more than its cash and short-term receivables combined.
This shortfall is significant relative to the very sizable market cap of US$15.7 billion, so it suggests shareholders should watch Diamondback Energy’s debt utilization. If its lenders require it to support the balance sheet, shareholders would likely face severe dilution.
To upgrade a company’s debt relative to revenue, we calculate net debt divided by revenue before interest, taxes, depreciation, and amortization (EBITDA) and revenue before interest and tax (EBIT) divided by interest expense (are interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with the interest coverage ratio).
Shareholders of Diamondback Energy are facing the double whammy of a high net debt-to-EBITDA ratio (6.4) and rather weak interest coverage, as EBIT is only 0.62 times interest expense. This means we consider it highly indebted. Even worse, Diamondback Energy saw its EBIT tank at 100% for the past 12 months. If long-term earnings continue to rise like this, there’s a snowball opportunity in hell to pay off that debt. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Diamondback Energy can strengthen its balance sheet over time. So if you’re focused on the future, check this out free Analyst earnings forecast report.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard money. So we always look at how much of that EBIT is translated into free cash flow. Overall, Diamondback Energy has seen significant negative free cash flow over the past three years. While that may be the result of spending on growth, it does make debt much more risky.
At first glance, Diamondback Energy’s conversion from EBIT to free cash flow left us hesitant about inventory, and the EBIT growth rate was no more attractive than that one empty restaurant on the busiest night of the year. And even net debt to EBITDA doesn’t inspire much confidence. Taking all of the above factors into account, it appears that Diamondback Energy has too much debt. That kind of risk is okay for some, but it certainly doesn’t keep our boat afloat. There is no doubt that we learn the most about debt from the balance sheet. But in the end, any business can contain risks that exist off-balance sheet. Be aware of Diamondback Energy can be seen 3 warning signs in our investment analysis , you should know about…
At the end of the day, it’s often better to focus on companies that are free of net debt. You can access our special list of such companies (all with a track record of earnings growth). It is free.
If you want to trade Diamondback Energy, open an account with the cheapest* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds around the world from a single integrated account.
This article from Simply Wall St is general in nature. It is not a recommendation to buy or sell stocks and does not take into account your objectives or your financial situation. We strive to provide you with long-term focused analysis powered by fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or quality material. Simply Wall St has no position in said stocks.
*Interactive Brokers Rated as Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Do you have any feedback on this article? Concerned about the content? Contact us directly with us. You can also email the editorial team at (at) Simplywallst.com.
🎬📺 Free Movies and Free TV Shows! 🎭🎬