Capricorn Metals (ASX:CMM) Seems To Use Debt Quite Sensibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Capricorn Metals Ltd (ASX:CMM) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Our analysis indicates that CMM is potentially undervalued!

How Much Debt Does Capricorn Metals Carry?

As you can see below, Capricorn Metals had AU$65.4m of debt at June 2022, down from AU$70.0m a year prior. However, it does have AU$63.3m in cash offsetting this, leading to net debt of about AU$2.06m.

How Strong Is Capricorn Metals' Balance Sheet?

The latest balance sheet data shows that Capricorn Metals had liabilities of AU$74.5m due within a year, and liabilities of AU$126.5m falling due after that. Offsetting this, it had AU$63.3m in cash and AU$1.76m in receivables that were due within 12 months. So it has liabilities totalling AU$135.9m more than its cash and near-term receivables, combined.

Since publicly traded Capricorn Metals shares are worth a total of AU$1.29b, 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. But either way, Capricorn Metals has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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

With debt at a measly 0.014 times EBITDA and EBIT covering interest a whopping 19.6 times, it's clear that Capricorn Metals is not a desperate borrower. So relative to past earnings, the debt load seems trivial. Although Capricorn Metals made a loss at the EBIT level, last year, it was also good to see that it generated AU$122m 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 Capricorn Metals'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. In the last year, Capricorn Metals's free cash flow amounted to 47% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Capricorn Metals's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its net debt to EBITDA also supports that impression! All these things considered, it appears that Capricorn Metals can comfortably handle its current debt levels. 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. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Capricorn Metals insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

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. 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.