Is Karoon Energy (ASX:KAR) Using Too Much Debt?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. 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?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Karoon Energy

What Is Karoon Energy's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 Karoon Energy had US$27.9m of debt, an increase on none, over one year. However, it does have US$204.1m in cash offsetting this, leading to net cash of US$176.2m.

A Look At Karoon Energy's Liabilities

The latest balance sheet data shows that Karoon Energy had liabilities of US$129.2m due within a year, and liabilities of US$693.3m falling due after that. Offsetting this, it had US$204.1m in cash and US$37.0m in receivables that were due within 12 months. So it has liabilities totalling US$581.4m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of US$939.6m. 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!

We also note that Karoon Energy improved its EBIT from a last year's loss to a positive US$105m. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Karoon Energy's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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. Happily for any shareholders, Karoon Energy actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While Karoon Energy does have more liabilities than liquid assets, it also has net cash of US$176.2m. And it impressed us with free cash flow of US$121m, being 116% of its EBIT. So we don't have any problem with Karoon Energy's use of debt. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Karoon Energy insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

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.