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. 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 South32 Limited (ASX:S32) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 South32's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 South32 had US$361.0m of debt, an increase on US$359, over one year. However, its balance sheet shows it holds US$1.41b in cash, so it actually has US$1.05b net cash.
How Healthy Is South32's Balance Sheet?
According to the last reported balance sheet, South32 had liabilities of US$1.69b due within 12 months, and liabilities of US$2.86b due beyond 12 months. Offsetting these obligations, it had cash of US$1.41b as well as receivables valued at US$895.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.24b.
South32 has a market capitalization of US$9.44b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, South32 boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for South32 if management cannot prevent a repeat of the 21% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine South32's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. South32 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. Over the last three years, South32 actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Although South32's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$1.05b. And it impressed us with free cash flow of US$1.1b, being 113% of its EBIT. So we don't have any problem with South32's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with South32 , and understanding them should be part of your investment process.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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