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 South32 Limited (ASX:S32) makes use of debt. But is this debt a concern to shareholders?
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 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does South32 Carry?
The image below, which you can click on for greater detail, shows that at June 2019 South32 had debt of US$361.0m, up from US$359 in one year. But on the other hand it also has US$1.41b in cash, leading to a US$1.05b net cash position.
How Healthy Is South32’s Balance Sheet?
According to the last reported balance sheet, South32 had liabilities of US$1.69b due within 12 months, and liabilities of US$2.86b due beyond 12 months. On the other hand, it had cash of US$1.41b and US$895.0m worth of receivables due within a year. So it has liabilities totalling US$2.24b more than its cash and near-term receivables, combined.
South32 has a market capitalization of US$9.35b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, South32 also has more cash than debt, so we’re pretty confident it can manage its debt safely.
The modesty of its debt load may become crucial for South32 if management cannot prevent a repeat of the 21% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if South32 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. South32 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. Over the last three years, South32 actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While South32 does have more liabilities than liquid assets, it also has net cash of US$1.05b. The cherry on top was that in converted 113% of that EBIT to free cash flow, bringing in US$1.1b. So we don’t have any problem with South32’s use of debt. 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. Consider for instance, the ever-present spectre of investment risk. We’ve identified 3 warning signs with South32 , and understanding them should be part of your investment process.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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