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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Major Drilling Group International Inc. (TSE:MDI) makes use of 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Major Drilling Group International's Debt?
The image below, which you can click on for greater detail, shows that Major Drilling Group International had debt of CA$15.7m at the end of January 2021, a reduction from CA$16.6m over a year. However, its balance sheet shows it holds CA$30.0m in cash, so it actually has CA$14.2m net cash.
A Look At Major Drilling Group International's Liabilities
According to the last reported balance sheet, Major Drilling Group International had liabilities of CA$59.8m due within 12 months, and liabilities of CA$32.0m due beyond 12 months. Offsetting these obligations, it had cash of CA$30.0m as well as receivables valued at CA$83.9m due within 12 months. So it actually has CA$22.1m more liquid assets than total liabilities.
This short term liquidity is a sign that Major Drilling Group International could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Major Drilling Group International has more cash than debt is arguably a good indication that it can manage its debt safely.
In fact Major Drilling Group International's saving grace is its low debt levels, because its EBIT has tanked 27% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Major Drilling Group International'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Major Drilling Group International 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. In the last two years, Major Drilling Group International's free cash flow amounted to 45% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Major Drilling Group International has net cash of CA$14.2m, as well as more liquid assets than liabilities. So we are not troubled with Major Drilling Group International's debt use. We'd be motivated to research the stock further if we found out that Major Drilling Group International insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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