We Think Kumba Iron Ore (JSE:KIO) Can Stay On Top Of Its Debt

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 Kumba Iron Ore Limited (JSE:KIO) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Kumba Iron Ore

What Is Kumba Iron Ore's Net Debt?

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.

A Look At Kumba Iron Ore's Liabilities

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. On the other hand, it had cash of R14.7b and R6.58b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R4.64b.

Since publicly traded Kumba Iron Ore shares are worth a total of R131.6b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Kumba Iron Ore also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Kumba Iron Ore if management cannot prevent a repeat of the 25% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Kumba Iron Ore 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Kumba Iron Ore 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. 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

We could understand if investors are concerned about Kumba Iron Ore's liabilities, but we can be reassured by the fact it has has net cash of R14.0b. 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Kumba Iron Ore has 1 warning sign we think you should be aware of.

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.