Here's Why Calima Energy (ASX:CE1) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Calima Energy Limited (ASX:CE1) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Calima Energy

How Much Debt Does Calima Energy Carry?

As you can see below, Calima Energy had AU$3.79m of debt at December 2022, down from AU$21.7m a year prior. But it also has AU$4.52m in cash to offset that, meaning it has AU$735.0k net cash.

How Healthy Is Calima Energy's Balance Sheet?

According to the last reported balance sheet, Calima Energy had liabilities of AU$21.9m due within 12 months, and liabilities of AU$26.4m due beyond 12 months. On the other hand, it had cash of AU$4.52m and AU$9.68m worth of receivables due within a year. So its liabilities total AU$34.1m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Calima Energy is worth AU$61.3m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Calima Energy also has more cash than debt, so we're pretty confident it can manage its debt safely.

Although Calima Energy made a loss at the EBIT level, last year, it was also good to see that it generated AU$32m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Calima Energy's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Calima Energy has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last year, Calima Energy created free cash flow amounting to 7.7% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

While Calima Energy does have more liabilities than liquid assets, it also has net cash of AU$735.0k. So we don't have any problem with Calima Energy's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Calima Energy , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.