Is Champion Iron (ASX:CIA) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Champion Iron Limited (ASX:CIA) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. 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 Champion Iron

What Is Champion Iron's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Champion Iron had debt of CA$323.4m, up from CA$215.0m in one year. However, because it has a cash reserve of CA$321.9m, its net debt is less, at about CA$1.47m.

A Look At Champion Iron's Liabilities

According to the last reported balance sheet, Champion Iron had liabilities of CA$286.9m due within 12 months, and liabilities of CA$540.6m due beyond 12 months. Offsetting these obligations, it had cash of CA$321.9m as well as receivables valued at CA$124.1m due within 12 months. So its liabilities total CA$381.5m more than the combination of its cash and short-term receivables.

Given Champion Iron has a market capitalization of CA$2.37b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. But either way, Champion Iron has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Champion Iron has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.0016 and EBIT of 290 times the interest expense. So relative to past earnings, the debt load seems trivial. Also good is that Champion Iron grew its EBIT at 12% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Champion Iron 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Champion Iron's free cash flow amounted to 28% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Champion Iron's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Champion Iron can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. Be aware that Champion Iron is showing 5 warning signs in our investment analysis , and 2 of those shouldn't be ignored...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.