Sandfire Resources (ASX:SFR) Takes On Some Risk With Its Use Of 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 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, Sandfire Resources Limited (ASX:SFR) does carry debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Sandfire Resources

What Is Sandfire Resources's Debt?

As you can see below, at the end of December 2022, Sandfire Resources had US$625.1m of debt, up from US$145.0m a year ago. Click the image for more detail. On the flip side, it has US$263.7m in cash leading to net debt of about US$361.4m.

A Look At Sandfire Resources' Liabilities

According to the last reported balance sheet, Sandfire Resources had liabilities of US$391.1m due within 12 months, and liabilities of US$1.02b due beyond 12 months. Offsetting these obligations, it had cash of US$263.7m as well as receivables valued at US$94.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.05b.

This deficit isn't so bad because Sandfire Resources is worth US$2.08b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Sandfire Resources's low debt to EBITDA ratio of 0.89 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.1 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, Sandfire Resources's EBIT fell a jaw-dropping 48% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sandfire Resources'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. Over the most recent three years, Sandfire Resources recorded free cash flow worth 77% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Sandfire Resources's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its conversion of EBIT to free cash flow was refreshing. We think that Sandfire Resources's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Case in point: We've spotted 2 warning signs for Sandfire Resources you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.