Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Evolution Mining Limited (ASX:EVN) does have debt on its balance sheet. But is this debt a concern to shareholders?
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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Evolution Mining's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Evolution Mining had AU$293.4m of debt in June 2019, down from AU$386.0m, one year before. But on the other hand it also has AU$335.2m in cash, leading to a AU$41.7m net cash position.
A Look At Evolution Mining's Liabilities
Zooming in on the latest balance sheet data, we can see that Evolution Mining had liabilities of AU$295.0m due within 12 months and liabilities of AU$392.4m due beyond that. On the other hand, it had cash of AU$335.2m and AU$83.2m worth of receivables due within a year. So its liabilities total AU$269.1m more than the combination of its cash and short-term receivables.
Since publicly traded Evolution Mining shares are worth a total of AU$8.12b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Evolution Mining also has more cash than debt, so we're pretty confident it can manage its debt safely.
But the other side of the story is that Evolution Mining saw its EBIT decline by 7.3% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Evolution Mining'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Evolution Mining 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. In the last three years, Evolution Mining created free cash flow amounting to 18% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
We could understand if investors are concerned about Evolution Mining's liabilities, but we can be reassured by the fact it has has net cash of AU$41.7m. So we don't have any problem with Evolution Mining's use of debt. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Evolution Mining insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
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