Lynas Rare Earths (ASX:LYC) Could Easily Take On More Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Lynas Rare Earths Limited (ASX:LYC) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out 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 as of June 2022 Lynas Rare Earths had AU$186.8m of debt, an increase on AU$171.1m, over one year. However, it does have AU$965.6m in cash offsetting this, leading to net cash of AU$778.8m.

A Look At Lynas Rare Earths' Liabilities

Zooming in on the latest balance sheet data, we can see that Lynas Rare Earths had liabilities of AU$123.6m due within 12 months and liabilities of AU$292.4m due beyond that. Offsetting these obligations, it had cash of AU$965.6m as well as receivables valued at AU$109.9m due within 12 months. So it actually has AU$659.4m more liquid assets than total liabilities.

This short term liquidity is a sign that Lynas Rare Earths could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Lynas Rare Earths boasts net cash, so it's fair to say it does not have a heavy debt load!

Even more impressive was the fact that Lynas Rare Earths grew its EBIT by 236% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Lynas Rare Earths has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last two years, Lynas Rare Earths produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Lynas Rare Earths has net cash of AU$778.8m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 236% over the last year. So we don't think Lynas Rare Earths's use of debt is risky. 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. Be aware that Lynas Rare Earths is showing 1 warning sign in our investment analysis , 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. 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.