Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Champion Iron Limited (ASX:CIA) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Champion Iron Carry?
You can click the graphic below for the historical numbers, but it shows that Champion Iron had CA$225.6m of debt in June 2019, down from CA$243.1m, one year before. However, because it has a cash reserve of CA$210.7m, its net debt is less, at about CA$15.0m.
A Look At Champion Iron's Liabilities
Zooming in on the latest balance sheet data, we can see that Champion Iron had liabilities of CA$146.8m due within 12 months and liabilities of CA$357.9m due beyond that. Offsetting these obligations, it had cash of CA$210.7m as well as receivables valued at CA$148.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$145.2m.
Since publicly traded Champion Iron shares are worth a total of CA$842.9m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With debt at a measly 0.037 times EBITDA and EBIT covering interest a whopping 11.2 times, it's clear that Champion Iron is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. It was also good to see that despite losing money on the EBIT line last year, Champion Iron turned things around in the last 12 months, delivering and EBIT of CA$386m. 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 Champion Iron 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. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Looking at the most recent year, Champion Iron recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
When it comes to the balance sheet, the standout positive for Champion Iron was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Considering this range of data points, we think Champion Iron is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. We'd be motivated to research the stock further if we found out that Champion Iron 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.
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