Is Challenger Exploration (ASX:CEL) A Risky Investment?

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. As with many other companies Challenger Exploration Limited (ASX:CEL) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Challenger Exploration

What Is Challenger Exploration's Debt?

As you can see below, at the end of June 2021, Challenger Exploration had AU$3.50m of debt, up from none a year ago. Click the image for more detail. But on the other hand it also has AU$47.5m in cash, leading to a AU$44.0m net cash position.

A Look At Challenger Exploration's Liabilities

Zooming in on the latest balance sheet data, we can see that Challenger Exploration had liabilities of AU$1.78m due within 12 months and liabilities of AU$5.52m due beyond that. On the other hand, it had cash of AU$47.5m and AU$309.9k worth of receivables due within a year. So it actually has AU$40.5m more liquid assets than total liabilities.

This excess liquidity suggests that Challenger Exploration is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Challenger Exploration has more cash than debt is arguably a good indication that it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, Challenger Exploration turned things around in the last 12 months, delivering and EBIT of AU$3.2m. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Challenger Exploration will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Challenger Exploration 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. Over the last year, Challenger Exploration saw substantial negative free cash flow, in total. 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 we empathize with investors who find debt concerning, you should keep in mind that Challenger Exploration has net cash of AU$44.0m, as well as more liquid assets than liabilities. So we are not troubled with Challenger Exploration's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Challenger Exploration (1 is concerning) you should be aware of.

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.
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