Here's Why Soma Gold (CVE:SOMA) 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.' 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. Importantly, Soma Gold Corp. (CVE:SOMA) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

View our latest analysis for Soma Gold

What Is Soma Gold's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2023 Soma Gold had CA$28.8m of debt, an increase on CA$19.6m, over one year. However, it also had CA$687.3k in cash, and so its net debt is CA$28.1m.

A Look At Soma Gold's Liabilities

The latest balance sheet data shows that Soma Gold had liabilities of CA$11.9m due within a year, and liabilities of CA$36.6m falling due after that. Offsetting this, it had CA$687.3k in cash and CA$6.94m in receivables that were due within 12 months. So it has liabilities totalling CA$40.8m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CA$59.4m, so it does suggest shareholders should keep an eye on Soma Gold's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 1.4 and interest cover of 2.9 times, it seems to us that Soma Gold is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. It is well worth noting that Soma Gold's EBIT shot up like bamboo after rain, gaining 95% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Soma Gold's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Soma Gold 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

Soma Gold's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Soma Gold'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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 4 warning signs we've spotted with Soma Gold (including 2 which shouldn't be ignored) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.