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. As with many other companies Gulf Keystone Petroleum Limited (LON:GKP) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Gulf Keystone Petroleum's Net Debt?
The chart below, which you can click on for greater detail, shows that Gulf Keystone Petroleum had US$98.9m in debt in June 2021; about the same as the year before. But on the other hand it also has US$189.5m in cash, leading to a US$90.7m net cash position.
How Strong Is Gulf Keystone Petroleum's Balance Sheet?
We can see from the most recent balance sheet that Gulf Keystone Petroleum had liabilities of US$106.5m falling due within a year, and liabilities of US$138.7m due beyond that. Offsetting this, it had US$189.5m in cash and US$110.8m in receivables that were due within 12 months. So it can boast US$55.1m more liquid assets than total liabilities.
This short term liquidity is a sign that Gulf Keystone Petroleum could probably pay off its debt with ease, as its balance sheet is far from stretched. 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$65m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Gulf Keystone Petroleum can strengthen its balance sheet over time. 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. Over the last year, Gulf Keystone Petroleum actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While we empathize with investors who find debt concerning, you should keep in mind that Gulf Keystone Petroleum has net cash of US$90.7m, as well as more liquid assets than liabilities. The cherry on top was that in converted 110% of that EBIT to free cash flow, bringing in US$71m. So we don't think Gulf Keystone Petroleum's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Gulf Keystone Petroleum (1 is a bit concerning!) 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.
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.
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