Is Anglo American (LON:AAL) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Anglo American plc (LON:AAL) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Anglo American

What Is Anglo American's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Anglo American had US$15.0b of debt, an increase on US$12.5b, over one year. However, it does have US$7.91b in cash offsetting this, leading to net debt of about US$7.14b.

A Look At Anglo American's Liabilities

The latest balance sheet data shows that Anglo American had liabilities of US$8.05b due within a year, and liabilities of US$25.5b falling due after that. Offsetting this, it had US$7.91b in cash and US$3.77b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$21.9b.

This is a mountain of leverage even relative to its gargantuan market capitalization of US$32.6b. 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.

Anglo American's net debt is only 0.73 times its EBITDA. And its EBIT covers its interest expense a whopping 25.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Anglo American's load is not too heavy, because its EBIT was down 44% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Anglo American's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Anglo American's free cash flow amounted to 48% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Anglo American's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Anglo American's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Anglo American .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.