Is Aurelia Metals (ASX:AMI) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Aurelia Metals Limited (ASX:AMI) does use debt in its business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Aurelia Metals

How Much Debt Does Aurelia Metals Carry?

As you can see below, at the end of December 2020, Aurelia Metals had AU$41.8m of debt, up from none a year ago. Click the image for more detail. But on the other hand it also has AU$105.8m in cash, leading to a AU$63.9m net cash position.

How Healthy Is Aurelia Metals' Balance Sheet?

We can see from the most recent balance sheet that Aurelia Metals had liabilities of AU$112.9m falling due within a year, and liabilities of AU$137.4m due beyond that. Offsetting this, it had AU$105.8m in cash and AU$18.5m in receivables that were due within 12 months. So its liabilities total AU$126.0m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Aurelia Metals is worth AU$456.9m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Aurelia Metals also has more cash than debt, so we're pretty confident it can manage its debt safely.

Better yet, Aurelia Metals grew its EBIT by 125% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Aurelia Metals can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Aurelia Metals 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. During the last three years, Aurelia Metals generated free cash flow amounting to a very robust 83% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

Although Aurelia Metals's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$63.9m. The cherry on top was that in converted 83% of that EBIT to free cash flow, bringing in AU$70m. So is Aurelia Metals's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Aurelia Metals has 4 warning signs we think you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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