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 Fitzroy River Corporation Limited (ASX:FZR) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
How Much Debt Does Fitzroy River Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2019 Fitzroy River had AU$5.02m of debt, an increase on none, over one year. However, its balance sheet shows it holds AU$8.36m in cash, so it actually has AU$3.34m net cash.
How Strong Is Fitzroy River's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Fitzroy River had liabilities of AU$11.7m due within 12 months and no liabilities due beyond that. Offsetting these obligations, it had cash of AU$8.36m as well as receivables valued at AU$303.0k due within 12 months. So it has liabilities totalling AU$3.09m more than its cash and near-term receivables, combined.
Of course, Fitzroy River has a market capitalization of AU$15.5m, so these liabilities are probably manageable. 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, Fitzroy River also has more cash than debt, so we're pretty confident it can manage its debt safely. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Fitzroy River will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Since Fitzroy River doesn't have significant operating revenue, shareholders must hope it'll sell some fossil fuels, before it runs out of money.
So How Risky Is Fitzroy River?
Statistically speaking companies that lose money are riskier than those that make money. And in the last year Fitzroy River had negative earnings before interest and tax (EBIT), truth be told. Indeed, in that time it burnt through AU$223k of cash and made a loss of AU$2.4m. But the saving grace is the AU$3.34m on the balance sheet. That kitty means the company can keep spending for growth for at least two years, at current rates. Overall, we'd say the stock is a bit risky, and we're usually very cautious until we see positive free cash flow. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Fitzroy River is showing 4 warning signs in our investment analysis , and 3 of those are potentially serious...
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. 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. Thank you for reading.
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