Is Emerald Resources (ASX:EMR) Using Too Much Debt?

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. We can see that Emerald Resources NL (ASX:EMR) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 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 Emerald Resources

How Much Debt Does Emerald Resources Carry?

The image below, which you can click on for greater detail, shows that Emerald Resources had debt of AU$78.5m at the end of June 2023, a reduction from AU$90.5m over a year. On the flip side, it has AU$71.5m in cash leading to net debt of about AU$7.02m.

How Healthy Is Emerald Resources' Balance Sheet?

The latest balance sheet data shows that Emerald Resources had liabilities of AU$98.1m due within a year, and liabilities of AU$70.9m falling due after that. On the other hand, it had cash of AU$71.5m and AU$15.9m worth of receivables due within a year. So its liabilities total AU$81.6m more than the combination of its cash and short-term receivables.

Since publicly traded Emerald Resources shares are worth a total of AU$1.47b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Emerald Resources has a very light debt load indeed.

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 has very modest net debt, giving rise to a debt to EBITDA ratio of 0.049. And EBIT easily covered the interest expense 9.6 times over, lending force to that view. Also good is that Emerald Resources grew its EBIT at 19% over the last year, further increasing its ability to manage debt. 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 Emerald Resources's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Over the most recent two years, Emerald Resources recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Emerald Resources's net debt to EBITDA 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 interest cover also supports that impression! Zooming out, Emerald Resources seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Emerald Resources's earnings per share history for free.

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.