Lynas Rare Earths (ASX:LYC) Seems To Use Debt Rather Sparingly

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.' 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. Importantly, Lynas Rare Earths Limited (ASX:LYC) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Lynas Rare Earths

What Is Lynas Rare Earths's Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Lynas Rare Earths had debt of AU$188.4m, up from AU$177.3m in one year. However, it does have AU$934.2m in cash offsetting this, leading to net cash of AU$745.8m.

How Healthy 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$178.9m due within 12 months and liabilities of AU$285.4m due beyond that. On the other hand, it had cash of AU$934.2m and AU$97.9m worth of receivables due within a year. So it actually has AU$567.8m 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. 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.

In addition to that, we're happy to report that Lynas Rare Earths has boosted its EBIT by 90%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Lynas Rare Earths 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 48% 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$745.8m in net cash and a decent-looking balance sheet. And we liked the look of last year's 90% year-on-year EBIT growth. So is Lynas Rare Earths's debt a risk? It doesn't seem so to us. 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. To that end, you should learn about the 2 warning signs we've spotted with Lynas Rare Earths (including 1 which makes us a bit uncomfortable) .

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.