Is Kunlun Energy (HKG:135) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, Kunlun Energy Company Limited (HKG:135) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Kunlun Energy

What Is Kunlun Energy's Net Debt?

As you can see below, Kunlun Energy had CN¥27.7b of debt at December 2020, down from CN¥34.5b a year prior. However, because it has a cash reserve of CN¥16.3b, its net debt is less, at about CN¥11.4b.

A Look At Kunlun Energy's Liabilities

We can see from the most recent balance sheet that Kunlun Energy had liabilities of CN¥44.6b falling due within a year, and liabilities of CN¥25.9b due beyond that. On the other hand, it had cash of CN¥16.3b and CN¥4.09b worth of receivables due within a year. So it has liabilities totalling CN¥50.1b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CN¥60.9b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Kunlun Energy's net debt is only 0.82 times its EBITDA. And its EBIT covers its interest expense a whopping 21.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Kunlun Energy's saving grace is its low debt levels, because its EBIT has tanked 42% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Kunlun 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Kunlun Energy recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Kunlun Energy's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. It's also worth noting that Kunlun Energy is in the Gas Utilities industry, which is often considered to be quite defensive. When we consider all the factors discussed, it seems to us that Kunlun Energy is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should be aware of the 2 warning signs we've spotted with Kunlun Energy .

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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