Leverage Ratios to Evaluate businesses

Investors in the oil and gas industry should observe the balance sheet’s debt levels. In such a capital-intensive industry, high debt levels can strain a company’s credit ratings. It would lessen its ability to buy new equipment or finance other capital projects. Furthermore, low credit ratings can also hurt their ability to acquire new businesses.

This is where analysts better understand how these companies perform against the competition and use particular leverage ratios to evaluate a company’s financial health. Therefore, investors can better understand these energy stocks’ fundamentals with a basic knowledge of these ratios in oil and gas.

First of all, debt is not always bad as using leverage can boost shareholder return. However, too much debt can become onerous. It is essential to know how well a business manages its dept. Therefore in order to evaluate, companies use several leverage ratios, such are Debt/EBITDA, EBIT/Interest Expense, Debt/Cap, and the Debt-to-Equity Ratios. Let us have a closer look.

Debt-to-EBITDA

What is the Debt/EBITDA ratio? Credit agencies generally use this ratio to assess a company’s ability to pay its debt. Significantly, it defines the possibility of defaulting on issued debt. For example, oil and gas companies typically have a lot of debt on their balance sheets. This ratio helps determine how many years of EBITDA would be needed to pay back all the debt. Besides, it can be worrying if the ratio is above 3, but this can change depending on the industry.

Additionally, the Debt/EBITDA ratio is the Debt/EBITDAX ratio, which is similar, except EBITDAX is EBITDA before exploration costs for strong efforts companies.

Still, it is important to note that there are several disadvantages to using this ratio. For example, it neglects all tax expenses when the government always gets paid first. Furthermore, principal repayments are not tax-deductible. A low ratio symbolizes that the company will be capable of paying back its debts faster. Additionally, Debt/EBITDA multiples can differ depending on the industry. That is why it is essential to only compare companies within the same sector, such as oil and gas.

EBIT/Interest Expense

Furthermore, oil and gas analysts use the interest coverage ratio to determine a firm’s ability to pay interest on outstanding debt. The greater the multiple is, there is less risk to the lender. If the company has a multiple greater than 1, it has enough capital to pay off its interest fees. Besides, it is essential to mention that the EBIT/Interest Expense metric does not consider taxes.

Debt-to-Capital

Notably, the debt-to-capital ratio is a measurement of a company’s financial leverage. It is among the meaningful debt ratios. It concentrates on the relationship of debt liabilities as a component of a company’s total capital base. Debt covers all short-term and long-term obligations. The capital covers the company’s debt and shareholder’s equity.

Significantly, the ratio mentioned above is used to assess a firm’s financial structure and how it is financing operations. Suppose a company has a high debt-to-capital ratio than its rivals. In that case, it may have a greater default risk due to the effect the debt has on its operations. For example, the oil industry has around a 40% debt-to-capital threshold. Over that level, debt costs rise considerably.

Debt-to-Equity

The next one is the debt/equity ratio, which probably is one of the essential financial leverage ratios. It is determined by dividing total liabilities by shareholders’ equity. Significantly, in this calculation, only long-term interest-bearing debt is used as the liabilities. This ratio shows what proportion of equity and debt a company uses to finance its assets. However, this ratio can vary among oil and gas firms, depending on their size.

If the company uses debt correctly, it can improve shareholder returns. However, too much debt leaves firms vulnerable to economic downturns and interest rate hikes. Besides, too much debt can also boost the business’s perceived risk and discourage investors from investing more capital.