David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that Golden Star Resources Ltd. (TSE:GSC) does have debt on its balance sheet. But is this debt a concern to shareholders?
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. 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 examine debt levels, we first consider both cash and debt levels, together.
What Is Golden Star Resources's Debt?
You can click the graphic below for the historical numbers, but it shows that Golden Star Resources had US$95.8m of debt in June 2019, down from US$108.2m, one year before. However, because it has a cash reserve of US$66.2m, its net debt is less, at about US$29.7m.
A Look At Golden Star Resources's Liabilities
According to the last reported balance sheet, Golden Star Resources had liabilities of US$132.4m due within 12 months, and liabilities of US$244.7m due beyond 12 months. On the other hand, it had cash of US$66.2m and US$5.33m worth of receivables due within a year. So its liabilities total US$305.6m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$309.6m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Given net debt is only 0.64 times EBITDA, it is initially surprising to see that Golden Star Resources's EBIT has low interest coverage of 1.0 times. So one way or the other, it's clear the debt levels are not trivial. Importantly, Golden Star Resources's EBIT fell a jaw-dropping 56% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Golden Star Resources can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Golden Star Resources burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, Golden Star Resources's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think Golden Star Resources has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given our concerns about Golden Star Resources's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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.
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