Is Champion Iron (ASX:CIA) A Risky Investment?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Champion Iron Limited (ASX:CIA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Champion Iron

What Is Champion Iron's Net Debt?

As you can see below, Champion Iron had CA$215.0m of debt at March 2021, down from CA$276.0m a year prior. However, its balance sheet shows it holds CA$609.3m in cash, so it actually has CA$394.4m net cash.

A Look At Champion Iron's Liabilities

Zooming in on the latest balance sheet data, we can see that Champion Iron had liabilities of CA$293.8m due within 12 months and liabilities of CA$350.1m due beyond that. Offsetting this, it had CA$609.3m in cash and CA$98.8m in receivables that were due within 12 months. So it can boast CA$64.2m more liquid assets than total liabilities.

This surplus suggests that Champion Iron has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Champion Iron has more cash than debt is arguably a good indication that it can manage its debt safely.

Better yet, Champion Iron grew its EBIT by 141% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. 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 Champion Iron'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Champion Iron 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, Champion Iron produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While it is always sensible to investigate a company's debt, in this case Champion Iron has CA$394.4m in net cash and a decent-looking balance sheet. And we liked the look of last year's 141% year-on-year EBIT growth. So is Champion Iron's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Champion Iron (of which 1 is potentially serious!) you should know about.

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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This article by Simply Wall St is general in nature. 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.
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