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 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 Kunlun Energy Company Limited (HKG:135) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Kunlun Energy

What Is Kunlun Energy's Net Debt?

As you can see below, Kunlun Energy had CN¥24.4b of debt at June 2022, down from CN¥25.6b a year prior. 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?

We can see from the most recent balance sheet that Kunlun Energy had liabilities of CN¥34.1b falling due within a year, 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 outweigh the sum of its cash and (near-term) receivables by CN¥17.8b.

This deficit isn't so bad because Kunlun Energy is worth CN¥50.5b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Kunlun Energy boasts net cash, so it's fair to say it does not have a heavy debt load!

Another good sign is that Kunlun Energy has been able to increase its EBIT by 23% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

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. Over the most recent three years, Kunlun Energy recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. 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. And it impressed us with free cash flow of CN¥4.1b, being 78% of its EBIT. So is Kunlun Energy's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. 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.