Is Sociedad Química y Minera de Chile (NYSE:SQM) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that Sociedad Química y Minera de Chile S.A. (NYSE:SQM) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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. 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 Sociedad Química y Minera de Chile

What Is Sociedad Química y Minera de Chile's Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Sociedad Química y Minera de Chile had debt of US$4.47b, up from US$2.92b in one year. However, it also had US$2.36b in cash, and so its net debt is US$2.11b.

How Strong Is Sociedad Química y Minera de Chile's Balance Sheet?

The latest balance sheet data shows that Sociedad Química y Minera de Chile had liabilities of US$2.35b due within a year, and liabilities of US$3.79b falling due after that. On the other hand, it had cash of US$2.36b and US$897.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.88b.

Sociedad Química y Minera de Chile has a very large market capitalization of US$13.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Sociedad Química y Minera de Chile has a low net debt to EBITDA ratio of only 0.67. And its EBIT easily covers its interest expense, being 422 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Sociedad Química y Minera de Chile's saving grace is its low debt levels, because its EBIT has tanked 48% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sociedad Química y Minera de Chile'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Sociedad Química y Minera de Chile recorded free cash flow of 24% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Sociedad Química y Minera de Chile's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Sociedad Química y Minera de Chile is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Sociedad Química y Minera de Chile (1 shouldn't be ignored!) that you should be aware of before investing here.

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.