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. Importantly, Largo Resources Ltd. (TSE:LGO) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Largo Resources Carry?
The image below, which you can click on for greater detail, shows that at June 2020 Largo Resources had debt of US$24.8m, up from US$22.4m in one year. However, it does have US$78.2m in cash offsetting this, leading to net cash of US$53.4m.
A Look At Largo Resources's Liabilities
According to the last reported balance sheet, Largo Resources had liabilities of US$39.1m due within 12 months, and liabilities of US$5.89m due beyond 12 months. On the other hand, it had cash of US$78.2m and US$9.63m worth of receivables due within a year. So it can boast US$42.9m more liquid assets than total liabilities.
This short term liquidity is a sign that Largo Resources could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Largo Resources boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact Largo Resources's saving grace is its low debt levels, because its EBIT has tanked 98% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Largo 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. Largo Resources may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Largo Resources recorded free cash flow worth a fulsome 95% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
While it is always sensible to investigate a company's debt, in this case Largo Resources has US$53.4m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of -US$76m, being 95% of its EBIT. So we are not troubled with Largo Resources's debt use. 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 Largo Resources is showing 2 warning signs in our investment analysis , you should know about...
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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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