Is Lynas Rare Earths (ASX:LYC) 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 note that Lynas Rare Earths Limited (ASX:LYC) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Lynas Rare Earths

What Is Lynas Rare Earths's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Lynas Rare Earths had AU$177.4m of debt in June 2023, down from AU$186.8m, one year before. However, its balance sheet shows it holds AU$1.01b in cash, so it actually has AU$833.8m net cash.

How Strong Is Lynas Rare Earths' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Lynas Rare Earths had liabilities of AU$165.0m due within 12 months and liabilities of AU$310.3m due beyond that. Offsetting this, it had AU$1.01b in cash and AU$59.6m in receivables that were due within 12 months. So it actually has AU$595.5m more liquid assets than total liabilities.

This surplus suggests that Lynas Rare Earths has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Lynas Rare Earths has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Lynas Rare Earths if management cannot prevent a repeat of the 47% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Lynas Rare Earths's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Lynas Rare Earths 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. In the last three years, Lynas Rare Earths's free cash flow amounted to 25% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Lynas Rare Earths has AU$833.8m in net cash and a decent-looking balance sheet. So we are not troubled with Lynas Rare Earths'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. For instance, we've identified 2 warning signs for Lynas Rare Earths (1 makes us a bit uncomfortable) you should be aware of.

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.