Kunlun Energy (HKG:135) Could Easily Take On More 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Kunlun Energy Company Limited (HKG:135) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Kunlun Energy

What Is Kunlun Energy's Net Debt?

The image below, which you can click on for greater detail, shows that Kunlun Energy had debt of CN¥24.4b at the end of June 2022, a reduction from CN¥25.6b over a year. But on the other hand it also has CN¥35.3b in cash, leading to a CN¥10.9b net cash position.

How Strong Is Kunlun Energy's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Kunlun Energy had liabilities of CN¥34.1b due within 12 months and liabilities of CN¥22.3b due beyond that. On the other hand, it had cash of CN¥35.3b and CN¥3.23b worth of receivables due within a year. So its liabilities total CN¥17.8b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Kunlun Energy is worth CN¥50.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Kunlun Energy also has more cash than debt, so we're pretty confident it can manage its debt safely.

Also positive, Kunlun Energy grew its EBIT by 23% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Kunlun Energy can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Kunlun Energy 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. During the last three years, Kunlun Energy produced sturdy free cash flow equating to 78% 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 Kunlun Energy does have more liabilities than liquid assets, it also has net cash of CN¥10.9b. The cherry on top was that in converted 78% of that EBIT to free cash flow, bringing in CN¥4.1b. So we don't think Kunlun Energy's use of debt is risky. 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 example, we've discovered 1 warning sign for Kunlun Energy that you should be aware of before investing here.

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.