Is Rey Resources (ASX:REY) Using Too Much Debt?

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. We can see that Rey Resources Limited (ASX:REY) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Rey Resources

What Is Rey Resources's Net Debt?

As you can see below, at the end of June 2022, Rey Resources had AU$12.9m of debt, up from AU$10.4m a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is Rey Resources' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Rey Resources had liabilities of AU$480.0k due within 12 months and liabilities of AU$16.4m due beyond that. On the other hand, it had cash of AU$172.0k and AU$9.0k worth of receivables due within a year. So its liabilities total AU$16.7m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of AU$25.4m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Rey Resources 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.

Given its lack of meaningful operating revenue, Rey Resources shareholders no doubt hope it can fund itself until it can sell some combustibles.

Caveat Emptor

Importantly, Rey Resources had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost AU$405k at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. However, it doesn't help that it burned through AU$1.2m of cash over the last year. So suffice it to say we do consider the stock to be risky. 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. For instance, we've identified 4 warning signs for Rey Resources (3 can't be ignored) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.