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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Hudbay Minerals Inc. (TSE:HBM) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Hudbay Minerals's Net Debt?
As you can see below, Hudbay Minerals had US$977.2m of debt at June 2019, down from US$1.06b a year prior. However, it also had US$489.5m in cash, and so its net debt is US$487.7m.
A Look At Hudbay Minerals's Liabilities
According to the last reported balance sheet, Hudbay Minerals had liabilities of US$326.3m due within 12 months, and liabilities of US$2.28b due beyond 12 months. Offsetting these obligations, it had cash of US$489.5m as well as receivables valued at US$92.3m due within 12 months. So it has liabilities totalling US$2.03b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$997.4m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we definitely think shareholders need to watch this one closely. After all, Hudbay Minerals would likely require a major re-capitalisation if it had to pay its creditors today.
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.
While Hudbay Minerals's low debt to EBITDA ratio of 0.98 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.8 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Shareholders should be aware that Hudbay Minerals's EBIT was down 61% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hudbay Minerals can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Hudbay Minerals actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
On the face of it, Hudbay Minerals's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Hudbay Minerals's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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.
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