Is West African Resources (ASX:WAF) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies West African Resources Limited (ASX:WAF) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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. 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.

Check out our latest analysis for West African Resources

How Much Debt Does West African Resources Carry?

The image below, which you can click on for greater detail, shows that at December 2023 West African Resources had debt of AU$147.2m, up from AU$14.1m in one year. However, it also had AU$135.1m in cash, and so its net debt is AU$12.1m.

How Healthy Is West African Resources' Balance Sheet?

We can see from the most recent balance sheet that West African Resources had liabilities of AU$128.6m falling due within a year, and liabilities of AU$186.4m due beyond that. Offsetting this, it had AU$135.1m in cash and AU$221.7m in receivables that were due within 12 months. So it actually has AU$41.7m more liquid assets than total liabilities.

This short term liquidity is a sign that West African Resources could probably pay off its debt with ease, as its balance sheet is far from stretched. But either way, West African Resources has virtually no net debt, so it's fair to say it does not have a heavy debt load!

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With debt at a measly 0.038 times EBITDA and EBIT covering interest a whopping 134 times, it's clear that West African Resources is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. On the other hand, West African Resources saw its EBIT drop by 8.6% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 West African Resources 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. So we always check how much of that EBIT is translated into free cash flow. In the last three years, West African Resources's free cash flow amounted to 26% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

West African Resources's interest cover was a real positive on this analysis, as was its net debt to EBITDA. On the other hand, its EBIT growth rate makes us a little less comfortable about its debt. Considering this range of data points, we think West African Resources is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that West African Resources is showing 1 warning sign in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.