Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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, GeoPark Limited (NYSE:GPRK) does carry debt. But should shareholders be worried about its use of debt?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
View our latest analysis for GeoPark
How Much Debt Does GeoPark Carry?
As you can see below, GeoPark had US$491.1m of debt at September 2022, down from US$674.9m a year prior. However, it does have US$93.0m in cash offsetting this, leading to net debt of about US$398.1m.
A Look At GeoPark’s Liabilities
According to the last reported balance sheet, GeoPark had liabilities of US$204.8m due within 12 months, and liabilities of US$615.4m due beyond 12 months. Offsetting this, it had US$93.0m in cash and US$59.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$668.1m.
This is a mountain of leverage relative to its market capitalization of US$861.8m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
GeoPark has a low net debt to EBITDA ratio of only 0.77. And its EBIT covers its interest expense a whopping 11.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that GeoPark grew its EBIT by 666% over twelve months. That boost will make it even easier to pay down debt going forward. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if GeoPark can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, GeoPark generated free cash flow amounting to a very robust 93% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
The good news is that GeoPark’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. Zooming out, GeoPark seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. For instance, we’ve identified 3 warning signs for GeoPark (1 can’t be ignored) you should be aware of.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
What are the risks and opportunities for GeoPark?
GeoPark Limited engages in the exploration, development, and production of oil and gas reserves in Chile, Colombia, Brazil, Argentina, and Ecuador.
Price-To-Earnings ratio (4.1x) is below the US market (15.3x)
Became profitable this year
Earnings are forecast to decline by an average of 10.1% per year for the next 3 years
Has a high level of debt
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.