Is African Rainbow Minerals (JSE:ARI) Using Debt In A Risky Way?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, African Rainbow Minerals Limited (JSE:ARI) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 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 Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 African Rainbow Minerals had debt of R1.02b, up from R117.0m in one year. However, its balance sheet shows it holds R8.99b in cash, so it actually has R7.97b net cash.

How Strong Is African Rainbow Minerals' Balance Sheet?

The latest balance sheet data shows that African Rainbow Minerals had liabilities of R5.49b due within a year, and liabilities of R7.11b falling due after that. Offsetting these obligations, it had cash of R8.99b as well as receivables valued at R5.41b due within 12 months. So it can boast R1.79b 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. 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're focused on the future you can check out this free report showing analyst profit forecasts.

In the last year African Rainbow Minerals had a loss before interest and tax, and actually shrunk its revenue by 22%, to R11b. That makes us nervous, to say the least.

So How Risky Is African Rainbow Minerals?

While African Rainbow Minerals lost money on an earnings before interest and tax (EBIT) level, it actually booked a paper profit of R3.1b. So taking that on face value, and considering the cash, we don't think its very risky in the near term. We'll feel more comfortable with the stock once EBIT is positive, given the lacklustre revenue growth. 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. To that end, you should learn about the 3 warning signs we've spotted with African Rainbow Minerals (including 1 which is a bit concerning) .

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.