Is Stanmore Resources (ASX:SMR) Using Too Much Debt?

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.' 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. As with many other companies Stanmore Resources Limited (ASX:SMR) makes use of 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. If things get really bad, the lenders can take control of the business. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Stanmore Resources

What Is Stanmore Resources's Net Debt?

As you can see below, at the end of June 2022, Stanmore Resources had US$776.6m of debt, up from US$43.6m a year ago. Click the image for more detail. However, it does have US$546.1m in cash offsetting this, leading to net debt of about US$230.5m.

How Strong Is Stanmore Resources' Balance Sheet?

The latest balance sheet data shows that Stanmore Resources had liabilities of US$729.5m due within a year, and liabilities of US$1.63b falling due after that. On the other hand, it had cash of US$546.1m and US$378.7m worth of receivables due within a year. So its liabilities total US$1.44b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's US$1.41b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Stanmore Resources has a low net debt to EBITDA ratio of only 0.48. And its EBIT covers its interest expense a whopping 22.2 times over. So we're pretty relaxed about its super-conservative use of debt. Although Stanmore Resources made a loss at the EBIT level, last year, it was also good to see that it generated US$430m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Stanmore Resources'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Stanmore Resources actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Stanmore Resources's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that Stanmore Resources is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Be aware that Stanmore Resources is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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.