Zimplats Holdings (ASX:ZIM) Could Easily Take On More 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.' 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 Zimplats Holdings Limited (ASX:ZIM) makes use of debt. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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. 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.

View our latest analysis for Zimplats Holdings

What Is Zimplats Holdings's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Zimplats Holdings had debt of US$11.8m, up from none in one year. But on the other hand it also has US$241.8m in cash, leading to a US$230.0m net cash position.

A Look At Zimplats Holdings' Liabilities

The latest balance sheet data shows that Zimplats Holdings had liabilities of US$198.6m due within a year, and liabilities of US$288.6m falling due after that. Offsetting these obligations, it had cash of US$241.8m as well as receivables valued at US$409.3m due within 12 months. So it can boast US$163.9m more liquid assets than total liabilities.

This surplus suggests that Zimplats Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Zimplats Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

Better yet, Zimplats Holdings grew its EBIT by 149% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Zimplats Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Zimplats Holdings 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. In the last three years, Zimplats Holdings's free cash flow amounted to 41% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While it is always sensible to investigate a company's debt, in this case Zimplats Holdings has US$230.0m in net cash and a decent-looking balance sheet. And we liked the look of last year's 149% year-on-year EBIT growth. So is Zimplats Holdings's debt a risk? It doesn't seem so to us. 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. For example, we've discovered 2 warning signs for Zimplats Holdings that you should be aware of before investing here.

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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