We Think South32 (ASX:S32) Can Stay On Top Of Its Debt

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 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 can see that South32 Limited (ASX:S32) does use debt in its business. 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for South32

What Is South32's Debt?

As you can see below, South32 had US$1.11b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$702.0m in cash, and so its net debt is US$409.0m.

How Strong Is South32's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that South32 had liabilities of US$1.47b due within 12 months and liabilities of US$3.70b due beyond that. Offsetting this, it had US$702.0m in cash and US$774.0m in receivables that were due within 12 months. So its liabilities total US$3.70b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since South32 has a huge market capitalization of US$11.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

South32 has a low debt to EBITDA ratio of only 0.33. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. It is just as well that South32's load is not too heavy, because its EBIT was down 78% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine South32's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, South32 produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Based on what we've seen South32 is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about South32's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. While South32 didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

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.