African Rainbow Minerals (JSE:ARI) Seems To Use Debt Rather Sparingly

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.' 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. Importantly, African Rainbow Minerals Limited (JSE:ARI) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for African Rainbow Minerals

What Is African Rainbow Minerals's Debt?

As you can see below, African Rainbow Minerals had R1.25b of debt at June 2021, down from R1.60b a year prior. But it also has R9.94b in cash to offset that, meaning it has R8.69b net cash.

A Look At African Rainbow Minerals' Liabilities

We can see from the most recent balance sheet that African Rainbow Minerals had liabilities of R3.36b falling due within a year, and liabilities of R5.96b due beyond that. On the other hand, it had cash of R9.94b and R7.90b worth of receivables due within a year. So it actually has R8.52b more liquid assets than total liabilities.

This surplus suggests that African Rainbow Minerals is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that African Rainbow Minerals has more cash than debt is arguably a good indication that it can manage its debt safely.

Better yet, African Rainbow Minerals grew its EBIT by 266% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 African Rainbow Minerals 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. African Rainbow Minerals 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. Over the last three years, African Rainbow Minerals actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

While it is always sensible to investigate a company's debt, in this case African Rainbow Minerals has R8.69b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of R7.0b, being 113% of its EBIT. The bottom line is that we do not find African Rainbow Minerals's debt levels at all concerning. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with African Rainbow Minerals (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.