Champion Iron (ASX:CIA) Seems To Use Debt Quite Sensibly

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. Importantly, Champion Iron Limited (ASX:CIA) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Champion Iron

How Much Debt Does Champion Iron Carry?

The image below, which you can click on for greater detail, shows that at December 2023 Champion Iron had debt of CA$536.0m, up from CA$449.2m in one year. On the flip side, it has CA$387.4m in cash leading to net debt of about CA$148.6m.

How Strong Is Champion Iron's Balance Sheet?

The latest balance sheet data shows that Champion Iron had liabilities of CA$316.1m due within a year, and liabilities of CA$948.6m falling due after that. On the other hand, it had cash of CA$387.4m and CA$181.2m worth of receivables due within a year. So it has liabilities totalling CA$696.1m more than its cash and near-term receivables, combined.

Since publicly traded Champion Iron shares are worth a total of CA$3.62b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Champion Iron's net debt is only 0.23 times its EBITDA. And its EBIT covers its interest expense a whopping 14.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Champion Iron has boosted its EBIT by 33%, thus reducing the spectre of future debt repayments. 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 Champion Iron can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Champion Iron created free cash flow amounting to 8.4% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

The good news is that Champion Iron's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Champion Iron is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Champion Iron has 1 warning sign 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.