Here's Why King Stone Energy Group (HKG:663) Can Afford Some 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. We can see that King Stone Energy Group Limited (HKG:663) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for King Stone Energy Group

How Much Debt Does King Stone Energy Group Carry?

As you can see below, King Stone Energy Group had HK$118.5m of debt at June 2023, down from HK$361.1m a year prior. However, it also had HK$64.1m in cash, and so its net debt is HK$54.5m.

How Strong Is King Stone Energy Group's Balance Sheet?

We can see from the most recent balance sheet that King Stone Energy Group had liabilities of HK$191.2m falling due within a year, and liabilities of HK$6.32m due beyond that. Offsetting these obligations, it had cash of HK$64.1m as well as receivables valued at HK$110.6m due within 12 months. So it has liabilities totalling HK$22.9m more than its cash and near-term receivables, combined.

Given King Stone Energy Group has a market capitalization of HK$154.3m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. There's no doubt that we learn most about debt from the balance sheet. But it is King Stone Energy Group's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

In the last year King Stone Energy Group wasn't profitable at an EBIT level, but managed to grow its revenue by 33%, to HK$158m. Shareholders probably have their fingers crossed that it can grow its way to profits.

Caveat Emptor

While we can certainly appreciate King Stone Energy Group's revenue growth, its earnings before interest and tax (EBIT) loss is not ideal. Its EBIT loss was a whopping HK$78m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled HK$10m in negative free cash flow over the last twelve months. So suffice it to say we consider the stock very risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with King Stone Energy Group (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.