Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Nexa Resources S.A. (NYSE:NEXA) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Nexa Resources's Net Debt?
The chart below, which you can click on for greater detail, shows that Nexa Resources had US$1.91b in debt in June 2021; about the same as the year before. However, it also had US$1.08b in cash, and so its net debt is US$839.3m.
A Look At Nexa Resources' Liabilities
We can see from the most recent balance sheet that Nexa Resources had liabilities of US$926.8m falling due within a year, and liabilities of US$2.49b due beyond that. Offsetting these obligations, it had cash of US$1.08b as well as receivables valued at US$232.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.11b.
The deficiency here weighs heavily on the US$1.04b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Nexa Resources would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Nexa Resources's low debt to EBITDA ratio of 1.1 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.1 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We also note that Nexa Resources improved its EBIT from a last year's loss to a positive US$481m. 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 Nexa Resources'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the most recent year, Nexa Resources recorded free cash flow worth 54% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
We'd go so far as to say Nexa Resources's level of total liabilities was disappointing. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Looking at the bigger picture, it seems clear to us that Nexa Resources's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For instance, we've identified 3 warning signs for Nexa Resources that you should be aware of.
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.
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