Is Iluka Resources (ASX:ILU) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Iluka Resources Limited (ASX:ILU) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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 Iluka Resources

What Is Iluka Resources's Net Debt?

The image below, which you can click on for greater detail, shows that Iluka Resources had debt of AU$36.9m at the end of December 2020, a reduction from AU$54.0m over a year. But it also has AU$87.1m in cash to offset that, meaning it has AU$50.2m net cash.

How Healthy Is Iluka Resources' Balance Sheet?

We can see from the most recent balance sheet that Iluka Resources had liabilities of AU$261.2m falling due within a year, and liabilities of AU$810.4m due beyond that. On the other hand, it had cash of AU$87.1m and AU$95.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$889.0m.

While this might seem like a lot, it is not so bad since Iluka Resources has a market capitalization of AU$3.18b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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.

It is just as well that Iluka Resources's load is not too heavy, because its EBIT was down 59% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Iluka Resources 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. 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 42% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Iluka Resources you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. 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.
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