Is Cenovus Energy (TSE:CVE) using too much debt?

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Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. Above all, Cenovus Energy Inc. (TSE:CVE) is in debt. But should shareholders worry about its use of debt?

Why is debt risky?

Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. If things go really bad, lenders can take over the business. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we look at debt levels, we first consider cash and debt levels, together.

Check out our latest analysis for Cenovus Energy

What is Cenovus Energy’s net debt?

The image below, which you can click on for more details, shows that as of December 2021, Cenovus Energy had C$12.5 billion in debt, up from C$7.56 billion in one year. However, since it has a cash reserve of C$2.87 billion, its net debt is less, at around C$9.59 billion.

TSX:CVE Debt to Equity April 11, 2022

How healthy is Cenovus Energy’s balance sheet?

Zooming in on the latest balance sheet data, we can see that Cenovus Energy had liabilities of C$7.31 billion due within 12 months and liabilities of C$23.2 billion due beyond. In compensation for these obligations, it had cash of 2.87 billion Canadian dollars as well as receivables valued at 3.04 billion Canadian dollars maturing within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of C$24.6 billion.

This shortfall isn’t that bad, as Cenovus Energy is worth C$43.9 billion and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

While Cenovus Energy’s low debt-to-EBITDA ratio of 1.2 suggests modest debt utilization, the fact that EBIT only covered interest expense by 6.1 times last year gives us pause. But the interest payments are certainly enough to make us think about the affordability of its debt. Although Cenovus Energy posted a loss in EBIT last year, it was also good to see that it generated C$4.3 billion in EBIT over the last twelve months. When analyzing debt levels, the balance sheet is the obvious starting point. But future earnings, more than anything, will determine Cenovus Energy’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, while the taxman may love accounting profits, lenders only accept cash. It is therefore worth checking how much of earnings before interest and tax (EBIT) is supported by free cash flow. Over the past year, Cenovus Energy has produced strong free cash flow equivalent to 79% of its EBIT, which is what we expected. This free cash flow puts the company in a good position to repay its debt, should it arise.

Our point of view

On the balance sheet, the most notable positive for Cenovus Energy is the fact that it appears to be able to convert EBIT to free cash flow with confidence. But the other factors we noted above weren’t so encouraging. For example, it looks like he has to struggle a bit to manage his total liabilities. When you consider all of the items mentioned above, it seems to us that Cenovus Energy is managing its debt quite well. That said, the charge is heavy enough that we recommend that any shareholder keep a close eye on it. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 3 warning signs for Cenovus Energy you should know.

If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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