Is Nickel Mines (ASX:NIC) A Risky Investment?

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. As with many other companies Nickel Mines Limited (ASX:NIC) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Nickel Mines

How Much Debt Does Nickel Mines Carry?

You can click the graphic below for the historical numbers, but it shows that Nickel Mines had US$45.0m of debt in December 2020, down from US$65.0m, one year before. But on the other hand it also has US$351.4m in cash, leading to a US$306.4m net cash position.

How Healthy Is Nickel Mines' Balance Sheet?

We can see from the most recent balance sheet that Nickel Mines had liabilities of US$57.7m falling due within a year, and liabilities of US$90.7m due beyond that. Offsetting these obligations, it had cash of US$351.4m as well as receivables valued at US$117.8m due within 12 months. So it actually has US$320.8m more liquid assets than total liabilities.

It's good to see that Nickel Mines has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Nickel Mines has more cash than debt is arguably a good indication that it can manage its debt safely.

While Nickel Mines doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. 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 Nickel Mines can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Nickel Mines 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. During the last two years, Nickel Mines produced sturdy free cash flow equating to 51% 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 Nickel Mines has net cash of US$306.4m, as well as more liquid assets than liabilities. So we don't think Nickel Mines's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Nickel Mines .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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