Is Gulf Keystone Petroleum (LON:GKP) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Gulf Keystone Petroleum Limited (LON:GKP) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Gulf Keystone Petroleum

What Is Gulf Keystone Petroleum's Net Debt?

As you can see below, Gulf Keystone Petroleum had US$99.1m of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$169.9m in cash offsetting this, leading to net cash of US$70.7m.

A Look At Gulf Keystone Petroleum's Liabilities

Zooming in on the latest balance sheet data, we can see that Gulf Keystone Petroleum had liabilities of US$98.8m due within 12 months and liabilities of US$143.8m due beyond that. Offsetting this, it had US$169.9m in cash and US$177.9m in receivables that were due within 12 months. So it can boast US$105.2m more liquid assets than total liabilities.

This surplus suggests that Gulf Keystone Petroleum is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, Gulf Keystone Petroleum boasts net cash, so it's fair to say it does not have a heavy debt load!

Although Gulf Keystone Petroleum made a loss at the EBIT level, last year, it was also good to see that it generated US$174m 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 Gulf Keystone Petroleum'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, a company can only pay off debt with cold hard cash, not accounting profits. Gulf Keystone Petroleum 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 year, Gulf Keystone Petroleum produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While it is always sensible to investigate a company's debt, in this case Gulf Keystone Petroleum has US$70.7m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of US$123m, being 71% of its EBIT. So we don't think Gulf Keystone Petroleum's use of debt is risky. 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 learn about the 3 warning signs we've spotted with Gulf Keystone Petroleum (including 1 which can't be ignored) .

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.