Is Gulf Keystone Petroleum (LON:GKP) A Risky Investment?

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Simply Wall St

Thu, May 19, 2022, 12:41 AM 4 min read

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.' 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, Gulf Keystone Petroleum Limited (LON:GKP) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Gulf Keystone Petroleum

What Is Gulf Keystone Petroleum's Debt?

The chart below, which you can click on for greater detail, shows that Gulf Keystone Petroleum had US$99.1m in debt in December 2021; about the same as the year before. However, it does have US$169.9m in cash offsetting this, leading to net cash of US$70.7m.

debt-equity-history-analysis — LSE:GKP Debt to Equity History May 19th 2022

A Look At Gulf Keystone Petroleum's Liabilities

Zooming in on the latest balance sheet data, we can see that Gulf Keystone Petroleum had liabilities of US$98.8m due within 12 months and liabilities of US$143.8m due beyond that. Offsetting these obligations, it had cash of US$169.9m as well as receivables valued at US$177.9m due within 12 months. So it can boast US$105.2m more liquid assets than total liabilities.

It's good to see that Gulf Keystone Petroleum has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Gulf Keystone Petroleum has more cash than debt is arguably a good indication that it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, Gulf Keystone Petroleum turned things around in the last 12 months, delivering and EBIT of US$174m. 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 Gulf Keystone Petroleum's ability to maintain a healthy balance sheet going forward. 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. While Gulf Keystone Petroleum 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 year, Gulf Keystone Petroleum produced sturdy free cash flow equating to 71% 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 Gulf Keystone Petroleum has net cash of US$70.7m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of US$123m, being 71% of its EBIT. 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 instance, we've identified 3 warning signs for Gulf Keystone Petroleum (1 shouldn't be ignored) you should be aware of.

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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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.