David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Horizon Oil Limited (ASX:HZN) does have debt on its balance sheet. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Horizon Oil

How Much Debt Does Horizon Oil Carry?

You can click the graphic below for the historical numbers, but it shows that Horizon Oil had US$12.1m of debt in June 2021, down from US$24.3m, one year before. But on the other hand it also has US$44.4m in cash, leading to a US$32.3m net cash position.

A Look At Horizon Oil's Liabilities

According to the last reported balance sheet, Horizon Oil had liabilities of US$29.1m due within 12 months, and liabilities of US$47.4m due beyond 12 months. Offsetting these obligations, it had cash of US$44.4m as well as receivables valued at US$15.0m due within 12 months. So its liabilities total US$17.1m more than the combination of its cash and short-term receivables.

Since publicly traded Horizon Oil shares are worth a total of US$96.9m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Horizon Oil also has more cash than debt, so we're pretty confident it can manage its debt safely.

We also note that Horizon Oil improved its EBIT from a last year's loss to a positive US$7.0m. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Horizon Oil will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Horizon Oil 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. Happily for any shareholders, Horizon Oil actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While Horizon Oil does have more liabilities than liquid assets, it also has net cash of US$32.3m. And it impressed us with free cash flow of US$16m, being 229% of its EBIT. So we are not troubled with Horizon Oil's debt use. 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. Case in point: We've spotted 4 warning signs for Horizon Oil you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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