David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Lynas Rare Earths Limited (ASX:LYC) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Lynas Rare Earths Carry?
You can click the graphic below for the historical numbers, but it shows that Lynas Rare Earths had AU$163.7m of debt in December 2020, down from AU$196.5m, one year before. However, it does have AU$512.6m in cash offsetting this, leading to net cash of AU$348.9m.
How Healthy Is Lynas Rare Earths' Balance Sheet?
We can see from the most recent balance sheet that Lynas Rare Earths had liabilities of AU$76.6m falling due within a year, and liabilities of AU$301.9m due beyond that. Offsetting these obligations, it had cash of AU$512.6m as well as receivables valued at AU$58.0m due within 12 months. So it actually has AU$192.2m 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!
Importantly, Lynas Rare Earths's EBIT fell a jaw-dropping 56% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 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. 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. Happily for any shareholders, Lynas Rare Earths actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While it is always sensible to investigate a company's debt, in this case Lynas Rare Earths has AU$348.9m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 124% of that EBIT to free cash flow, bringing in -AU$3.7m. So we are not troubled with Lynas Rare Earths's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Lynas Rare Earths has 3 warning signs we think you should be aware of.
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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