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 Centerra Gold Inc. (TSE:CG) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Centerra Gold's Debt?
The image below, which you can click on for greater detail, shows that Centerra Gold had debt of US$94.4m at the end of June 2019, a reduction from US$290.2m over a year. But it also has US$140.0m in cash to offset that, meaning it has US$45.5m net cash.
How Healthy Is Centerra Gold's Balance Sheet?
According to the last reported balance sheet, Centerra Gold had liabilities of US$300.4m due within 12 months, and liabilities of US$349.0m due beyond 12 months. Offsetting this, it had US$140.0m in cash and US$65.6m in receivables that were due within 12 months. So its liabilities total US$443.8m more than the combination of its cash and short-term receivables.
Of course, Centerra Gold has a market capitalization of US$2.40b, so these liabilities are probably manageable. 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, Centerra Gold also has more cash than debt, so we're pretty confident it can manage its debt safely.
It is just as well that Centerra Gold's load is not too heavy, because its EBIT was down 31% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Centerra Gold 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Centerra Gold 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, Centerra Gold generated free cash flow amounting to a very robust 84% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
While Centerra Gold does have more liabilities than liquid assets, it also has net cash of US$46m. The cherry on top was that in converted 84% of that EBIT to free cash flow, bringing in US$128m. So we don't have any problem with Centerra Gold's use of debt. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Centerra Gold 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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