Here's Why Emerald Resources (ASX:EMR) Has A Meaningful Debt Burden

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 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 Emerald Resources NL (ASX:EMR) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, 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 Emerald Resources

What Is Emerald Resources's Net Debt?

As you can see below, at the end of December 2021, Emerald Resources had AU$99.1m of debt, up from AU$78.2m a year ago. Click the image for more detail. However, it does have AU$18.1m in cash offsetting this, leading to net debt of about AU$81.1m.

A Look At Emerald Resources' Liabilities

According to the last reported balance sheet, Emerald Resources had liabilities of AU$72.6m due within 12 months, and liabilities of AU$112.7m due beyond 12 months. Offsetting these obligations, it had cash of AU$18.1m as well as receivables valued at AU$9.38m due within 12 months. So it has liabilities totalling AU$157.8m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Emerald Resources is worth AU$690.5m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

Emerald Resources's debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 2.9 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. One redeeming factor for Emerald Resources is that it turned last year's EBIT loss into a gain of AU$11m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Emerald Resources's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Emerald Resources burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Emerald Resources's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its level of total liabilities is not so bad. Once we consider all the factors above, together, it seems to us that Emerald Resources's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. We've identified 3 warning signs with Emerald Resources (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.

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.