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

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Karoon Energy Ltd (ASX:KAR) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Karoon Energy

What Is Karoon Energy's Debt?

As you can see below, Karoon Energy had US$28.1m of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds US$74.8m in cash, so it actually has US$46.7m net cash.

A Look At Karoon Energy's Liabilities

Zooming in on the latest balance sheet data, we can see that Karoon Energy had liabilities of US$196.2m due within 12 months and liabilities of US$520.6m due beyond that. Offsetting these obligations, it had cash of US$74.8m as well as receivables valued at US$71.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$570.9m.

While this might seem like a lot, it is not so bad since Karoon Energy has a market capitalization of US$959.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Karoon Energy also has more cash than debt, so we're pretty confident it can manage its debt safely.

In addition to that, we're happy to report that Karoon Energy has boosted its EBIT by 58%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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. During the last three years, Karoon Energy burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

While Karoon Energy does have more liabilities than liquid assets, it also has net cash of US$46.7m. And we liked the look of last year's 58% year-on-year EBIT growth. So we don't have any problem with Karoon Energy's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Karoon Energy .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.