Is South32 (ASX:S32) 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. We note that South32 Limited (ASX:S32) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

How Much Debt Does South32 Carry?

The image below, which you can click on for greater detail, shows that South32 had debt of US$987.0m at the end of December 2024, a reduction from US$1.11b over a year. However, it does have US$1.60b in cash offsetting this, leading to net cash of US$613.0m.

How Healthy Is South32's Balance Sheet?

According to the last reported balance sheet, South32 had liabilities of US$1.23b due within 12 months, and liabilities of US$3.45b due beyond 12 months. Offsetting these obligations, it had cash of US$1.60b as well as receivables valued at US$778.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.30b.

South32 has a market capitalization of US$9.54b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. 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.

View our latest analysis for South32

It was also good to see that despite losing money on the EBIT line last year, South32 turned things around in the last 12 months, delivering and EBIT of US$547m. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if South32 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While South32 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 year, South32 produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While South32 does have more liabilities than liquid assets, it also has net cash of US$613.0m. The cherry on top was that in converted 68% of that EBIT to free cash flow, bringing in US$373m. So we are not troubled with South32's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with South32 .

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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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.