Here's Why Japan Petroleum Exploration (TSE:1662) Can Manage Its Debt Responsibly

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Japan Petroleum Exploration Co., Ltd. (TSE:1662) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Japan Petroleum Exploration

How Much Debt Does Japan Petroleum Exploration Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Japan Petroleum Exploration had JP¥20.0b of debt, an increase on none, over one year. However, it does have JP¥133.7b in cash offsetting this, leading to net cash of JP¥113.7b.

How Strong Is Japan Petroleum Exploration's Balance Sheet?

According to the last reported balance sheet, Japan Petroleum Exploration had liabilities of JP¥74.9b due within 12 months, and liabilities of JP¥74.8b due beyond 12 months. On the other hand, it had cash of JP¥133.7b and JP¥40.3b worth of receivables due within a year. So it actually has JP¥24.4b more liquid assets than total liabilities.

This surplus suggests that Japan Petroleum Exploration has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Japan Petroleum Exploration boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that Japan Petroleum Exploration has seen its EBIT plunge 15% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Japan Petroleum Exploration 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 Japan Petroleum 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. During the last three years, Japan Petroleum Exploration produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Japan Petroleum Exploration has net cash of JP¥113.7b, as well as more liquid assets than liabilities. So we don't have any problem with Japan Petroleum Exploration's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example Japan Petroleum Exploration has 2 warning signs (and 1 which can't be ignored) we think you should know about.

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.