Fortuna Silver Mines (TSE:FVI) Has A Somewhat Strained Balance Sheet

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. We note that Fortuna Silver Mines Inc. (TSE:FVI) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Our analysis indicates that FVI is potentially undervalued!

What Is Fortuna Silver Mines's Net Debt?

As you can see below, at the end of June 2022, Fortuna Silver Mines had US$218.6m of debt, up from US$160.1m a year ago. Click the image for more detail. However, it does have US$116.4m in cash offsetting this, leading to net debt of about US$102.2m.

How Healthy Is Fortuna Silver Mines' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Fortuna Silver Mines had liabilities of US$127.2m due within 12 months and liabilities of US$480.6m due beyond that. On the other hand, it had cash of US$116.4m and US$68.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$422.8m.

While this might seem like a lot, it is not so bad since Fortuna Silver Mines has a market capitalization of US$822.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Fortuna Silver Mines's net debt is only 0.35 times its EBITDA. And its EBIT easily covers its interest expense, being 12.5 times the size. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Fortuna Silver Mines has seen its EBIT plunge 12% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Fortuna Silver Mines can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Fortuna Silver Mines saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We'd go so far as to say Fortuna Silver Mines's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Fortuna Silver Mines stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Fortuna Silver Mines that you should be aware of before investing here.

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.