Here's Why Wesdome Gold Mines (TSE:WDO) Has A Meaningful Debt Burden

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.' 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 Wesdome Gold Mines Ltd. (TSE:WDO) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Wesdome Gold Mines

What Is Wesdome Gold Mines's Debt?

As you can see below, at the end of December 2022, Wesdome Gold Mines had CA$54.7m of debt, up from none a year ago. Click the image for more detail. However, because it has a cash reserve of CA$33.2m, its net debt is less, at about CA$21.5m.

A Look At Wesdome Gold Mines' Liabilities

We can see from the most recent balance sheet that Wesdome Gold Mines had liabilities of CA$115.6m falling due within a year, and liabilities of CA$105.0m due beyond that. On the other hand, it had cash of CA$33.2m and CA$17.8m worth of receivables due within a year. So it has liabilities totalling CA$169.6m more than its cash and near-term receivables, combined.

Of course, Wesdome Gold Mines has a market capitalization of CA$1.24b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). 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).

Wesdome Gold Mines has net debt of just 0.36 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.6 times the interest expense over the last year. The modesty of its debt load may become crucial for Wesdome Gold Mines if management cannot prevent a repeat of the 80% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Wesdome Gold Mines'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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Wesdome Gold Mines burned a lot of cash. 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

Both Wesdome Gold Mines's EBIT growth rate and its conversion of EBIT to free cash flow were discouraging. But on the brighter side of life, its net debt to EBITDA leaves us feeling more frolicsome. Taking the abovementioned factors together we do think Wesdome Gold Mines's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

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.