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.' 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. We can see that Stanmore Resources Limited (ASX:SMR) 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 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.

Check out our latest analysis for Stanmore Resources

What Is Stanmore Resources's 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.

A Look At Stanmore Resources' Liabilities

According to the last reported balance sheet, Stanmore Resources had liabilities of US$729.5m due within 12 months, and liabilities of US$1.63b due beyond 12 months. Offsetting these obligations, it had cash of US$546.1m as well as receivables valued at US$378.7m due within 12 months. So it has liabilities totalling US$1.44b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of US$1.58b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Stanmore Resources's net debt is only 0.48 times its EBITDA. And its EBIT easily covers its interest expense, being 22.2 times the size. 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. When analysing debt levels, the balance sheet is the obvious place to start. 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 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. 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. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

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. Considering this range of data points, we think Stanmore Resources is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Stanmore Resources has 2 warning signs we think 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.

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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.