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. Importantly, Iluka Resources Limited (ASX:ILU) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Iluka Resources Carry?
You can click the graphic below for the historical numbers, but it shows that Iluka Resources had AU$36.9m of debt in December 2020, down from AU$54.0m, one year before. However, its balance sheet shows it holds AU$87.1m in cash, so it actually has AU$50.2m net cash.
A Look At Iluka Resources' Liabilities
Zooming in on the latest balance sheet data, we can see that Iluka Resources had liabilities of AU$261.2m due within 12 months and liabilities of AU$810.4m due beyond that. Offsetting this, it had AU$87.1m in cash and AU$81.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$902.9m.
Iluka Resources has a market capitalization of AU$3.30b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Iluka Resources also has more cash than debt, so we're pretty confident it can manage its debt safely.
The modesty of its debt load may become crucial for Iluka Resources if management cannot prevent a repeat of the 46% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Iluka 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Iluka Resources may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Iluka Resources recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Although Iluka Resources's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$50.2m. So we are not troubled with Iluka Resources's debt use. We'd be motivated to research the stock further if we found out that Iluka Resources insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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