South32 (ASX:S32) Seems To Use Debt Quite Sensibly
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. As with many other companies South32 Limited (ASX:S32) makes use of debt. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for South32
What Is South32's Debt?
The chart below, which you can click on for greater detail, shows that South32 had US$421.0m in debt in December 2020; about the same as the year before. But on the other hand it also has US$1.39b in cash, leading to a US$971.0m net cash position.
How Healthy Is South32's Balance Sheet?
According to the last reported balance sheet, South32 had liabilities of US$1.47b due within 12 months, and liabilities of US$3.53b due beyond 12 months. On the other hand, it had cash of US$1.39b and US$594.0m worth of receivables due within a year. So its liabilities total US$3.01b more than the combination of its cash and short-term receivables.
South32 has a very large market capitalization of US$10.4b, 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. While it does have liabilities worth noting, South32 also has more cash than debt, so we're pretty confident it can manage its debt safely.
Importantly, South32's EBIT fell a jaw-dropping 94% 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. The balance sheet is clearly the area to focus on when you are analysing debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While South32 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. Happily for any shareholders, South32 actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Summing up
While South32 does have more liabilities than liquid assets, it also has net cash of US$971.0m. And it impressed us with free cash flow of US$506m, being 158% of its EBIT. So we are not troubled with South32's debt use. We'd be motivated to research the stock further if we found out that South32 insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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