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.' 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. As with many other companies Kumba Iron Ore Limited (JSE:KIO) makes use of debt. But the real question is whether this debt is making the company risky.

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When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Kumba Iron Ore Carry?

You can click the graphic below for the historical numbers, but it shows that Kumba Iron Ore had R2.00b of debt in December 2024, down from R4.14b, one year before. However, its balance sheet shows it holds R16.9b in cash, so it actually has R14.9b net cash.

How Healthy Is Kumba Iron Ore's Balance Sheet?

According to the last reported balance sheet, Kumba Iron Ore had liabilities of R12.1b due within 12 months, and liabilities of R17.4b due beyond 12 months. On the other hand, it had cash of R16.9b and R5.80b worth of receivables due within a year. So it has liabilities totalling R6.73b more than its cash and near-term receivables, combined.

Given Kumba Iron Ore has a market capitalization of R90.6b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. 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.

Check out our latest analysis for Kumba Iron Ore

The modesty of its debt load may become crucial for Kumba Iron Ore if management cannot prevent a repeat of the 43% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Kumba Iron Ore's ability to maintain a healthy balance sheet going forward. 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 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. During the last three years, Kumba Iron Ore produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Kumba Iron Ore has R14.9b in net cash. And it impressed us with free cash flow of R23b, being 66% of its EBIT. So we don't have any problem with Kumba Iron Ore's use of debt. 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. Be aware that Kumba Iron Ore is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...

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.