Here's Why African Rainbow Minerals (JSE:ARI) Can Manage Its Debt Responsibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that African Rainbow Minerals Limited (JSE:ARI) 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 and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for African Rainbow Minerals

What Is African Rainbow Minerals's Debt?

You can click the graphic below for the historical numbers, but it shows that African Rainbow Minerals had R94.0m of debt in December 2023, down from R137.0m, one year before. But on the other hand it also has R8.59b in cash, leading to a R8.50b net cash position.

How Strong Is African Rainbow Minerals' Balance Sheet?

The latest balance sheet data shows that African Rainbow Minerals had liabilities of R3.47b due within a year, and liabilities of R6.49b falling due after that. Offsetting this, it had R8.59b in cash and R5.41b in receivables that were due within 12 months. So it can boast R4.05b more liquid assets than total liabilities.

This short term liquidity is a sign that African Rainbow Minerals could probably pay off its debt with ease, as its balance sheet is far from stretched. 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.

It is just as well that African Rainbow Minerals's load is not too heavy, because its EBIT was down 87% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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. Happily for any shareholders, African Rainbow Minerals actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that African Rainbow Minerals has net cash of R8.50b, as well as more liquid assets than liabilities. The cherry on top was that in converted 119% of that EBIT to free cash flow, bringing in R3.3b. So we don't have any problem with African Rainbow Minerals's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for African Rainbow Minerals 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.