Here's Why Kumba Iron Ore (JSE:KIO) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Kumba Iron Ore Limited (JSE:KIO) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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.

Check out our latest analysis for Kumba Iron Ore

How Much Debt Does Kumba Iron Ore Carry?

As you can see below, at the end of June 2023, Kumba Iron Ore had R725.0m of debt, up from none a year ago. Click the image for more detail. But on the other hand it also has R14.7b in cash, leading to a R14.0b net cash position.

How Healthy Is Kumba Iron Ore's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Kumba Iron Ore had liabilities of R11.5b due within 12 months and liabilities of R14.4b due beyond that. Offsetting these obligations, it had cash of R14.7b as well as receivables valued at R6.58b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R4.64b.

Given Kumba Iron Ore has a humongous market capitalization of R191.5b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Kumba Iron Ore boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Kumba Iron Ore's saving grace is its low debt levels, because its EBIT has tanked 25% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Kumba Iron Ore 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 Kumba Iron Ore 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 most recent three years, Kumba Iron Ore recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Kumba Iron Ore has R14.0b in net cash. And it impressed us with free cash flow of R16b, being 68% of its EBIT. So we are not troubled with Kumba Iron Ore's debt use. 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. For instance, we've identified 1 warning sign for Kumba Iron Ore that you should be aware of.

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.

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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.