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.' 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 Amerigo Resources Ltd. (TSE:ARG) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Amerigo Resources

How Much Debt Does Amerigo Resources Carry?

You can click the graphic below for the historical numbers, but it shows that Amerigo Resources had US$19.0m of debt in March 2024, down from US$24.3m, one year before. On the flip side, it has US$14.5m in cash leading to net debt of about US$4.55m.

How Strong Is Amerigo Resources' Balance Sheet?

We can see from the most recent balance sheet that Amerigo Resources had liabilities of US$48.7m falling due within a year, and liabilities of US$45.1m due beyond that. On the other hand, it had cash of US$14.5m and US$15.8m worth of receivables due within a year. So its liabilities total US$63.5m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Amerigo Resources has a market capitalization of US$235.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 0.20 times EBITDA, it is initially surprising to see that Amerigo Resources's EBIT has low interest coverage of 0.51 times. So one way or the other, it's clear the debt levels are not trivial. Importantly, Amerigo Resources's EBIT fell a jaw-dropping 92% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Amerigo 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Amerigo Resources generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

We weren't impressed with Amerigo Resources's interest cover, and its EBIT growth rate made us cautious. But its conversion of EBIT to free cash flow was significantly redeeming. When we consider all the factors mentioned above, we do feel a bit cautious about Amerigo Resources's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Amerigo Resources you should know about.

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.

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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.