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Is 5N Plus (TSE:VNP) Using Too Much Debt?

Simply Wall St

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 5N Plus Inc. (TSE:VNP) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for 5N Plus

What Is 5N Plus's Net Debt?

As you can see below, at the end of March 2019, 5N Plus had US$55.2m of debt, up from US$48.3m a year ago. Click the image for more detail. However, because it has a cash reserve of US$22.2m, its net debt is less, at about US$33.0m.

TSX:VNP Historical Debt, July 27th 2019

How Strong Is 5N Plus's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that 5N Plus had liabilities of US$44.8m due within 12 months and liabilities of US$82.3m due beyond that. On the other hand, it had cash of US$22.2m and US$33.7m worth of receivables due within a year. So it has liabilities totalling US$71.3m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since 5N Plus has a market capitalization of US$139.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While 5N Plus's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.6 last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Unfortunately, 5N Plus saw its EBIT slide 4.3% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine 5N Plus'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, 5N Plus actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Mulling over 5N Plus's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. Overall, we think it's fair to say that 5N Plus has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.