Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Korab Resources Limited (ASX:KOR) does use debt in its business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.
What Is Korab Resources's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 Korab Resources had AU$2.40m of debt, an increase on AU$1.93m, over one year. However, it also had AU$71.7k in cash, and so its net debt is AU$2.33m.
How Strong Is Korab Resources' Balance Sheet?
We can see from the most recent balance sheet that Korab Resources had liabilities of AU$472.7k falling due within a year, and liabilities of AU$2.36m due beyond that. On the other hand, it had cash of AU$71.7k and AU$47.8k worth of receivables due within a year. So it has liabilities totalling AU$2.71m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of AU$4.32m, so it does suggest shareholders should keep an eye on Korab Resources' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Korab Resources's debt to EBITDA ratio (3.4) suggests that it uses some debt, its interest cover is very weak, at 2.2, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Investors should also be troubled by the fact that Korab Resources saw its EBIT drop by 11% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Korab Resources will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Korab Resources burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Korab Resources's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. Overall, it seems to us that Korab Resources's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Be aware that Korab Resources is showing 3 warning signs in our investment analysis , and 2 of those are a bit unpleasant...
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.
When trading Korab Resources or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account.
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.