Eastern Platinum (TSE:ELR) Use Of Debt Could Be Considered Risky

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Eastern Platinum Limited (TSE:ELR) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

View our latest analysis for Eastern Platinum

How Much Debt Does Eastern Platinum Carry?

The chart below, which you can click on for greater detail, shows that Eastern Platinum had US$49.5m in debt in September 2022; about the same as the year before. However, it does have US$1.18m in cash offsetting this, leading to net debt of about US$48.3m.

How Healthy Is Eastern Platinum's Balance Sheet?

We can see from the most recent balance sheet that Eastern Platinum had liabilities of US$67.1m falling due within a year, and liabilities of US$9.23m due beyond that. Offsetting this, it had US$1.18m in cash and US$30.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$44.3m.

This deficit casts a shadow over the US$15.1m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Eastern Platinum would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Eastern Platinum shareholders face the double whammy of a high net debt to EBITDA ratio (8.4), and fairly weak interest coverage, since EBIT is just 0.59 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Eastern Platinum is that it turned last year's EBIT loss into a gain of US$2.4m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Eastern Platinum's earnings that will influence how the balance sheet holds up in the future. 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. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Eastern Platinum burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Eastern Platinum's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Considering all the factors previously mentioned, we think that Eastern Platinum really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. Be aware that Eastern Platinum is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

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.