Sociedad Química y Minera de Chile (NYSE:SQM) Takes On Some Risk With Its Use Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Sociedad Química y Minera de Chile S.A. (NYSE:SQM) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at 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?

As you can see below, at the end of June 2024, Sociedad Química y Minera de Chile had US$4.46b of debt, up from US$3.39b a year ago. Click the image for more detail. However, it does have US$2.12b in cash offsetting this, leading to net debt of about US$2.34b.

A Look At Sociedad Química y Minera de Chile's Liabilities

Zooming in on the latest balance sheet data, we can see that Sociedad Química y Minera de Chile had liabilities of US$2.39b due within 12 months and liabilities of US$3.41b due beyond that. Offsetting this, it had US$2.12b in cash and US$1.10b in receivables that were due within 12 months. So it has liabilities totalling US$2.57b more than its cash and near-term receivables, combined.

Sociedad Química y Minera de Chile has a very large market capitalization of US$11.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). 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 1.2. And its EBIT easily covers its interest expense, being 31.3 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Sociedad Química y Minera de Chile's saving grace is its low debt levels, because its EBIT has tanked 67% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sociedad Química y Minera de Chile can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Sociedad Química y Minera de Chile's free cash flow amounted to 26% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

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 the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Sociedad Química y Minera de Chile's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Sociedad Química y Minera de Chile (2 are 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.

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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.