David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Karoon Energy Ltd (ASX:KAR) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
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What Is Karoon Energy's Net Debt?
The chart below, which you can click on for greater detail, shows that Karoon Energy had US$27.6m in debt in December 2022; about the same as the year before. However, its balance sheet shows it holds US$163.2m in cash, so it actually has US$135.6m net cash.
How Strong Is Karoon Energy's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Karoon Energy had liabilities of US$256.5m due within 12 months and liabilities of US$621.2m due beyond that. On the other hand, it had cash of US$163.2m and US$79.3m worth of receivables due within a year. So its liabilities total US$635.2m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$863.1m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, Karoon Energy boasts net cash, so it's fair to say it does not have a heavy debt load!
Better yet, Karoon Energy grew its EBIT by 102% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Karoon Energy can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Karoon Energy may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last two years, Karoon Energy's free cash flow amounted to 40% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Summing Up
Although Karoon Energy's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$135.6m. And we liked the look of last year's 102% year-on-year EBIT growth. So we don't have any problem with Karoon Energy's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Karoon Energy has 1 warning sign we think you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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.
About ASX:KAR
Karoon Energy
Operates as an oil and gas exploration and production company in Brazil, the United States, and Australia.
Very undervalued with solid track record.