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 Grange Resources Limited (ASX:GRR) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. If things get really bad, the lenders can take control of the business. 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 examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Grange Resources Carry?
As you can see below, at the end of June 2019, Grange Resources had AU$13.7m of debt, up from AU$3.13m a year ago. Click the image for more detail. However, its balance sheet shows it holds AU$149.6m in cash, so it actually has AU$136.0m net cash.
How Healthy Is Grange Resources's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Grange Resources had liabilities of AU$58.1m due within 12 months and liabilities of AU$71.9m due beyond that. On the other hand, it had cash of AU$149.6m and AU$37.5m worth of receivables due within a year. So it can boast AU$57.1m more liquid assets than total liabilities.
It's good to see that Grange Resources 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 Grange Resources has more cash than debt is arguably a good indication that it can manage its debt safely.
It is just as well that Grange Resources's load is not too heavy, because its EBIT was down 42% 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 it is Grange Resources's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Grange Resources 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, Grange Resources produced sturdy free cash flow equating to 57% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to investigate a company's debt, in this case Grange Resources has AU$136m in net cash and a decent-looking balance sheet. So we don't have any problem with Grange Resources's use of debt. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Grange Resources insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.