Is African Rainbow Minerals (JSE:ARI) A Risky Investment?

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 can see that African Rainbow Minerals Limited (JSE:ARI) does use debt in its business. But should shareholders be worried about its use of debt?

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. 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. The first step when considering a company's debt levels is to consider 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 R137.0m of debt in December 2022, down from R819.0m, one year before. But it also has R10.4b in cash to offset that, meaning it has R10.2b 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 R3.21b falling due within a year, and liabilities of R5.82b due beyond that. Offsetting these obligations, it had cash of R10.4b as well as receivables valued at R6.33b due within 12 months. So it actually has R7.67b more liquid assets than total liabilities.

This excess liquidity suggests that African Rainbow Minerals is taking a careful approach to debt. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, African Rainbow Minerals boasts net cash, so it's fair to say it does not have a heavy debt load!

But the other side of the story is that African Rainbow Minerals saw its EBIT decline by 6.0% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. 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 company can only pay off debt with cold hard cash, not accounting profits. While African Rainbow Minerals has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, African Rainbow Minerals recorded free cash flow worth a fulsome 100% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that African Rainbow Minerals has net cash of R10.2b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of R7.8b, being 100% of its EBIT. So we don't think African Rainbow Minerals's use of debt is risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for African Rainbow Minerals (of which 1 is significant!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.