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Here's Why SouthGobi Resources (TSE:SGQ) Might Be Better Off Without Debt

Simply Wall St

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that SouthGobi Resources Ltd. (TSE:SGQ) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for SouthGobi Resources

What Is SouthGobi Resources's Net Debt?

As you can see below, at the end of March 2019, SouthGobi Resources had US$148.5m of debt, up from US$130.2m a year ago. Click the image for more detail. However, it does have US$8.85m in cash offsetting this, leading to net debt of about US$139.7m.

TSX:SGQ Historical Debt, July 30th 2019

A Look At SouthGobi Resources's Liabilities

Zooming in on the latest balance sheet data, we can see that SouthGobi Resources had liabilities of US$269.6m due within 12 months and liabilities of US$7.33m due beyond that. On the other hand, it had cash of US$8.85m and US$5.85m worth of receivables due within a year. So it has liabilities totalling US$262.3m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$29.0m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, SouthGobi Resources would probably need a major re-capitalization if its creditors were to demand repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is SouthGobi Resources's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Over 12 months, SouthGobi Resources saw its revenue drop to US$116m, which is a fall of 3.3%. That's not what we would hope to see.

Caveat Emptor

Over the last twelve months SouthGobi Resources produced an earnings before interest and tax (EBIT) loss. To be specific the EBIT loss came in at US$2.7m. When you combine this with the very significant balance sheet liabilities mentioned above, we are so wary of it that we are basically at a loss for the right words. Like every long-shot we're sure it has a glossy presentation outlining its blue-sky potential. But the reality is that it is low on liquid assets relative to liabilities, and it lost US$36m in the last year. So we think buying this stock is risky, like walking through a minefield with a mask on. When we look at a riskier company, we like to check how their profits (or losses) are trending over time. Today, we're providing readers this interactive graph showing how SouthGobi Resources's profit, revenue, and operating cashflow have changed over the last few years.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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.