SouthGobi Resources (TSE:SGQ) Is Using Debt In A Risky Way

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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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. As with many other companies. SouthGobi Resources Ltd. (TSE:SGQ) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 SouthGobi Resources

What Is SouthGobi Resources’s Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2019 SouthGobi Resources had US$148.5m of debt, an increase on US$130.2m, over one year. However, it does have US$8.85m in cash offsetting this, leading to net debt of about US$139.7m.

TSX:SGQ Historical Debt, July 18th 2019
TSX:SGQ Historical Debt, July 18th 2019

A Look At SouthGobi Resources’s Liabilities

Zooming in on the latest balance sheet data, we can see that SouthGobi Resources had liabilities of US$269.6m due within 12 months and liabilities of US$7.33m due beyond that. On the other hand, it had cash of US$8.85m and US$5.85m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$262.3m.

This deficit casts a shadow over the US$33.4m company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt After all, SouthGobi Resources would likely require a major re-capitalisation if it had to pay its creditors today. Either way, since SouthGobi Resources does have more debt than cash, it’s worth keeping an eye on its balance sheet. 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 SouthGobi Resources will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Over 12 months, SouthGobi Resources saw its revenue drop to US$116m, which is a fall of 3.3%. We would much prefer see growth.

Caveat Emptor

Importantly, SouthGobi Resources had negative earnings before interest and tax (EBIT), over the last year. To be specific the EBIT loss came in at US$2.7m. When you combine this with the very significant balance sheet liabilities mentioned above, we are so wary of it that we are basically at a loss for the right words. Sure, the company might have a nice story about how they are going on to a brighter future. But the reality is that it is low on liquid assets relative to liabilities, and it lost US$36m in the last year. So we think buying this stock is risky, like walking through a minefield with a mask on. When we look at a riskier company, we like to check how their profits (or losses) are trending over time. Today, we’re providing readers this interactive graph showing how SouthGobi Resources’s profit, revenue, and operating cashflow have changed over the last few years.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.