How Safe Is Your Money In BP plc?

BP (LSE: BP) (NYSE: BP.US) shares currently offer a 5.0% prospective yield, broadly in-line with that available from UK peer Royal Dutch Shell.

However, the threat of a $20bn fine continues to hang over BP, whereas Shell faces no such risk. Are BP’s finances really so strong that it shareholders don’t need to demand a ‘risk premium’ — a higher yield — for holding the firm’s shares?

I’ve been taking a closer look at BP’s finances to find out more.

1. Operating profit/interest

What we’re looking for here is a ratio of at least 1.5, preferably over 2, to show that BP’s operational profits cover its interest payments with room to spare:

Profit before interest and taxation / net charge for interest and other finance expense

$31,769m / $323m = 98.4 times cover

BP’s debt levels remain very low — even if it is required to make a worst-case $20bn-plus payment as a penalty for the Gulf of Mexico spill, it’s hard to see BP’s dividend coming under serious threat, as long as the price of oil remains firm.

BP2. Debt/equity ratio

Commonly referred to as gearing, this is simply the ratio of debt to shareholder equity, or book value (total assets – total liabilities). I tend to use net debt, as companies often maintain large cash balances that can be used to reduce debt if necessary.

At the end of 2013, BP reported net debt of $25.7bn and equity of $130.4bn, giving net gearing of 20%, which I’m very comfortable with.

3. Operating profit/sales

This ratio is usually known as operating margin and is useful measure of a company’s profitability.

Profit before interest and taxation / Sales and other operating revenues

$31,769m / $379,136m = 8.4%

BP reported an operating margin of 8.4% for 2013, placing it midway in terms of profitability between Shell(6.0%) and French oil major Total SA (10.4%).

Is BP a safe buy?

BP shares currently trade on a P/E of 10, but this undemanding valuation may change rapidly when the uncertainty of BP’s oil spill court case is resolved later this year.

My gut feeling is that BP won’t be found guilty of gross negligence for the Gulf of Mexico oil spill. This should mean that the fine is limited to around $5bn, which would be fairly insignificant for the firm, which reported an operating profit of $31bn last year.

I think BP shares offer an attractive balance of risk and reward at the moment. However, if you already own shares in BP, or are considering an investment, I would strongly suggest you take a look at "How To Create Dividends For Life", before making a final decision.

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Roland owns shares in Royal Dutch Shell but does not own shares in any of the other companies mentioned in this article.