Investors within the oil and gas industry should keep an eye on the debt levels on the balance sheet. It is such a capital-intensive industry that high levels of debt can put a strain on a company's credit ratings, weakening their ability to purchase new equipment or finance other capital projects. Poor credit ratings can also harm its ability to acquire new businesses.

SEE: Debt Ratios: Introduction

This is where analysts, to give a better idea of how these companies fare against the competition, use specific leverage ratios in assessing the financial health of a company. With a basic understanding of these ratios in oil and gas, investors can better understand the fundamentals of oil and gas stocks.

It is important to note that 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. Since it is important to know how well a business is managing its debt, the following leverage ratios are used: Debt/EBITDA, EBIT/Interest Expense, Debt/Cap and the Debt-to-Equity Ratios. EBIT and EBITDA are two metrics that, in theory, can be used to pay the interest on the debt and repay the principal.

The Debt-to-EBITDA leverage ratio 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 oil and gas companies typically have a lot of debt on their balance sheets, this ratio is useful in determining how many years of EBITDA would be necessary in order 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.

Another variation of the Debt/EBITDA ratio is the Debt/EBITDAX ratio, which is similar, except EBITDAX is EBITDA before exploration costs for successful efforts companies. It is commonly used in the United States 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 noncash 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 this ratio. 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. Along with that, Debt/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. (For related reading, see A Clear Look At EBITDA.)

Interest Coverage Ratio: EBIT/Interest Expense
The interest coverage ratio is used by oil and gas analysts to determine a firm's ability to pay interest on outstanding debt. The greater the multiple, the less risk to the lender and typically, if the company has a multiple higher than one, they are considered to have enough capital to pay off its interest expenses. An oil and gas company should cover their interest and fixed charges by at least a factor of two, or even more ideally, 3:1. If not, its ability to meet interest payments may be questionable. Also keep in mind that the EBIT/Interest Expense metric does not take into account taxes. (For more, see Why Interest Coverage Matters To Investors.)

Debt-to-Capital: Debt/Cap
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. Cap or capital includes the company's debt and shareholder's equity.

The ratio is used to evaluate a firm's financial structure and how it's financing operations. Typically, if a company has a high debt-to-capital ratio amongst its peers, then it may have an increased default risk due to the effect the debt has on its operations. The oil industry seems to have about a 40% debt-to-capital threshold. Above that level, debt costs increase considerably.

Debt-to-Equity: Debt/Equity
The debt/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. It is important to note, however, that this ratio can widely vary between oil and gas firms, depending on their size.

The Bottom Line
Debt when used properly can increase shareholder returns. Having too much, however, leaves firms vulnerable to economic downturns and interest rate hikes. Too much debt can also increase the perceived risk with the business and discourage investors from investing more capital.

Using these four leverage ratios used in oil and gas can give investors an inside look at how well these firms are managing their debt. There are others, of course, and one ratio should never be used in isolation; rather, because of different capital structures, more than one should be used to evaluate an oil company's ability to pay its debts. (For additional reading, check out Evaluating A Company's Capital Structure.)

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