One of the keys for investors in the energy sector is to keep an eye on debt levels. The sector is capital-intensive, and high levels of debt can put a strain on a company's credit ratings, weakening its ability to purchase new equipment or finance other capital projects. High debt levels can also hamper its ability to meet other obligations. However, analysts and investors can use specific leverage ratios to assess the financial health of an energy company.
- The energy sector is capital intensive, which makes paying special attention to leverage important.
- The four key ratios for analysts and investors to use when analyzing the energy sector include—debt-to-EBITDA, interest coverage ratio, debt-to-capital, and debt-to-equity.
- Debt can increase shareholder returns, as the cost of debt is lower than the cost of equity.
- Too much debt can become burdensome and limit a company's ability to meet other obligations or get financing for new projects/equipment.
4 Leverage Ratios Used In Evaluating Energy Firms
Debt-to-EBITDA measures a company's ability to pay off its incurred debt. Commonly used by credit agencies, it determines the probability of defaulting on issued debt. Since energy companies typically have a lot of debt on their balance sheets, this ratio is useful in determining how many years of earnings before interest, taxes, depreciation, and amortization (EBITDA) would be necessary to pay back all the debt. Typically, it can be alarming if the ratio is over three, but this can vary depending on the industry.
A variation of the debt-to-EBITDA ratio is debt-to-EBITDAX which is similar, except it uses earnings before interest, taxes, depreciation, amortization, and exploration expenses (EBITDAX). It is commonly used to normalize different accounting treatments for exploration expenses (the full cost method versus the successful efforts method).
Exploration costs are typically found in the financial statements as exploration, abandonment, and dry hole costs. Other non-cash expenses that should be added back in are impairments, accretion of asset retirement obligations, and deferred taxes.
However, there are a few disadvantages to using debt-to-EBITDA (or debt-to-EBITDAX). For one, it ignores all tax expenses when the government always gets paid first. Additionally, principal repayments are not tax-deductible.
A low ratio indicates that the company will be able to pay back its debts faster. However, average debt-to-EBITDA multiples can vary depending on the industry. This is why it is important to only compare companies within the same industry, such as oil and gas.
2. Interest Coverage Ratio
The interest coverage ratio is used by oil and gas analysts to determine a firm's ability to pay interest on outstanding debt, calculated as earnings before interest and taxes (EBIT) divided by interest expense. The greater the multiple, the less risk to the lender, and typically, if the company has a multiple higher than 1, they are considered to have enough capital to pay off its interest expenses.
Like EBITDA, EBIT does not take into account taxes. EBIT and EBITDA are popular metrics used to determine how much cash is available to repay debt.
The debt-to-capital ratio is a measurement of a company's financial leverage. It is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a company's total capital base. Debt includes all short-term and long-term obligations, while capital includes the company's debt and shareholder's equity.
The ratio is used to evaluate a firm's financial structure and how its financing operations. Typically, if a company has a high debt-to-capital ratio compared to its peers, then it may have a higher default risk due to the effect the debt has on its operations.
The debt-to-equity ratio, probably one of the most common financial leverage ratios, is calculated by dividing total liabilities by shareholders' equity. Typically, only interest-bearing long-term debt is used as the liabilities in this calculation. However, analysts may make adjustments to include or exclude certain items.
The ratio indicates what proportion of equity and debt a company uses to finance its assets. This ratio can widely vary between oil and gas firms, depending on their size.
The Bottom Line
Debt is not inherently bad—using leverage can increase shareholder returns, as the cost of debt is lower than the cost of equity. That said, too much debt can become burdensome—called being over-leveraged. This represents the inflection point where the risks and costs of over-leverage outweigh the benefits of leverage.
Using the above four leverage ratios can give investors an inside look at how well these firms are managing their debt. There are others, and one ratio should never be used in isolation.