These 4 Measures Indicate That African Rainbow Minerals (JSE:ARI) Is Using Debt Reasonably Well

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.' 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 should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See 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 African Rainbow Minerals had debt of R321.0m at the end of June 2022, a reduction from R1.25b over a year. But on the other hand it also has R12.3b in cash, leading to a R12.0b net cash position.

How Healthy Is African Rainbow Minerals' Balance Sheet?

The latest balance sheet data shows that African Rainbow Minerals had liabilities of R3.30b due within a year, and liabilities of R5.51b falling due after that. On the other hand, it had cash of R12.3b and R7.85b worth of receivables due within a year. So it actually has R11.4b more liquid assets than total liabilities.

It's good to see that African Rainbow Minerals has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. 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.

In fact African Rainbow Minerals's saving grace is its low debt levels, because its EBIT has tanked 28% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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. During the last three years, African Rainbow Minerals generated free cash flow amounting to a very robust 96% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While it is always sensible to investigate a company's debt, in this case African Rainbow Minerals has R12.0b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 96% of that EBIT to free cash flow, bringing in R8.9b. So is African Rainbow Minerals's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for African Rainbow Minerals (1 is potentially serious!) that you should be aware of before investing here.

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.

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.