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 note that Sociedad Química y Minera de Chile S.A. (NYSE:SQM) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Sociedad Química y Minera de Chile's Debt?
As you can see below, Sociedad Química y Minera de Chile had US$1.94b of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has US$1.95b in cash, leading to a US$5.10m net cash position.
How Healthy Is Sociedad Química y Minera de Chile's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Sociedad Química y Minera de Chile had liabilities of US$581.3m due within 12 months and liabilities of US$2.20b due beyond that. Offsetting these obligations, it had cash of US$1.95b as well as receivables valued at US$622.7m due within 12 months. So its liabilities total US$208.8m more than the combination of its cash and short-term receivables.
Having regard to Sociedad Química y Minera de Chile's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the US$15.5b company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, Sociedad Química y Minera de Chile boasts net cash, so it's fair to say it does not have a heavy debt load!
And we also note warmly that Sociedad Química y Minera de Chile grew its EBIT by 15% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Sociedad Química y Minera de Chile may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Sociedad Química y Minera de Chile created free cash flow amounting to 8.0% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
We could understand if investors are concerned about Sociedad Química y Minera de Chile's liabilities, but we can be reassured by the fact it has has net cash of US$5.10m. On top of that, it increased its EBIT by 15% in the last twelve months. So we don't have any problem with Sociedad Química y Minera de Chile's use of debt. 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 instance, we've identified 2 warning signs for Sociedad Química y Minera de Chile (1 is potentially serious) you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.