Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Pan African Resources PLC (LON:PAF) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Pan African Resources's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Pan African Resources had US$87.2m of debt in December 2020, down from US$113.2m, one year before. However, it also had US$28.0m in cash, and so its net debt is US$59.3m.
How Strong Is Pan African Resources' Balance Sheet?
According to the last reported balance sheet, Pan African Resources had liabilities of US$71.4m due within 12 months, and liabilities of US$120.6m due beyond 12 months. Offsetting these obligations, it had cash of US$28.0m as well as receivables valued at US$22.3m due within 12 months. So its liabilities total US$141.6m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Pan African Resources is worth US$510.8m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Pan African Resources's net debt is only 0.51 times its EBITDA. And its EBIT covers its interest expense a whopping 11.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Pan African Resources grew its EBIT by 64% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Pan African Resources 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Pan African Resources 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.
Based on what we've seen Pan African Resources is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its EBIT growth rate. Considering this range of data points, we think Pan African Resources is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Be aware that Pan African Resources is showing 2 warning signs in our investment analysis , you should know about...
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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