Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies New Gold Inc. (TSE:NGD) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does New Gold Carry?
The image below, which you can click on for greater detail, shows that New Gold had debt of US$489.6m at the end of March 2021, a reduction from US$750.2m over a year. However, because it has a cash reserve of US$190.9m, its net debt is less, at about US$298.7m.
A Look At New Gold's Liabilities
The latest balance sheet data shows that New Gold had liabilities of US$146.8m due within a year, and liabilities of US$1.23b falling due after that. Offsetting this, it had US$190.9m in cash and US$86.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.10b.
This deficit is considerable relative to its market capitalization of US$1.13b, so it does suggest shareholders should keep an eye on New Gold's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
New Gold has a very low debt to EBITDA ratio of 1.1 so it is strange to see weak interest coverage, with last year's EBIT being only 2.4 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that New Gold improved its EBIT from a last year's loss to a positive US$103m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if New Gold 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. In the last year, New Gold's free cash flow amounted to 23% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, New Gold's level of total liabilities left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Once we consider all the factors above, together, it seems to us that New Gold's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. We've identified 1 warning sign with New Gold , and understanding them should be part of your investment process.
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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