Amerigo Resources (TSE:ARG) Seems To Use Debt Quite Sensibly

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, Amerigo Resources Ltd. (TSE:ARG) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Amerigo Resources

What Is Amerigo Resources's Net Debt?

The chart below, which you can click on for greater detail, shows that Amerigo Resources had US$55.9m in debt in December 2020; about the same as the year before. However, it does have US$14.1m in cash offsetting this, leading to net debt of about US$41.9m.

How Strong Is Amerigo Resources' Balance Sheet?

We can see from the most recent balance sheet that Amerigo Resources had liabilities of US$49.8m falling due within a year, and liabilities of US$77.1m due beyond that. On the other hand, it had cash of US$14.1m and US$21.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$91.4m.

Amerigo Resources has a market capitalization of US$170.2m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Amerigo Resources has a very low debt to EBITDA ratio of 1.5 so it is strange to see weak interest coverage, with last year's EBIT being only 2.0 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that Amerigo Resources improved its EBIT from a last year's loss to a positive US$10m. 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 Amerigo Resources 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Amerigo Resources actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On our analysis Amerigo Resources's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. When we consider all the factors mentioned above, we do feel a bit cautious about Amerigo Resources's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Amerigo Resources (of which 1 is concerning!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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. 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.
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