Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say this when he says “The biggest risk in investing is not price volatility, but if you will suffer a loss. permanent capital “. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Above all, Comstock Resources, Inc. (NYSE: CRK) is in debt. But the real question is whether this debt makes the business risky.
When is Debt a Problem?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. If things really go wrong, lenders can take over the business. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, many companies use debt to finance their growth without negative consequences. When we think of a business’s use of debt, we first look at cash flow and debt together.
What is the debt of Comstock Resources?
The image below, which you can click for more details, shows that in September 2021, Comstock Resources was in debt of US $ 2.80 billion, up from US $ 2.51 billion in a year. And he doesn’t have a lot of cash, so his net debt is about the same.
NYSE: CRK Debt to Equity History December 2, 2021
How healthy is Comstock Resources’ balance sheet?
The latest balance sheet data shows Comstock Resources had US $ 1.06 billion in liabilities due within one year, and US $ 2.99 billion in liabilities due after that. In compensation for these obligations, it had cash of US $ 27.8 million as well as receivables valued at US $ 243.2 million due within 12 months. It therefore has liabilities totaling US $ 3.79 billion more than its cash and short-term receivables combined.
This deficit casts a shadow over the $ 1.88 billion company as a colossus towering over mere mortals. We would therefore monitor its record closely, without a doubt. Ultimately, Comstock Resources would likely need a major recapitalization if its creditors demanded repayment.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Comstock Resources’ net debt stands at a very reasonable level of 2.4 times its EBITDA, while its EBIT only covered its interest expense 3.0 times last year. While this doesn’t worry us too much, it does suggest that the interest payments are somewhat of a burden. Notably, Comstock Resources’ EBIT was higher than Elon Musk’s, gaining a whopping 335% from last year. 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 Comstock Resources can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Comstock Resources has reported free cash flow of 11% of its EBIT, which is really pretty low. For us, the conversion to cash that elicits a bit of paranoia is the ability to extinguish debt.
Our point of view
Reflecting on Comstock Resources’ attempt to stay on top of its total liabilities, we are certainly not enthusiastic. But at least it’s decent enough to increase your EBIT; it’s encouraging. Overall, we think it’s fair to say that Comstock Resources has enough debt that there is real risk around the balance sheet. If all goes well it may pay off, but the downside to this debt is a greater risk of permanent losses. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example – Comstock Resources has 1 warning sign we think you should be aware.
If you want to invest in companies that can generate profits without the burden of debt, check out this free list of growing companies that have net cash on the balance sheet.
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