Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 note that OZ Minerals Limited (ASX:OZL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does OZ Minerals Carry?
As you can see below, at the end of June 2019, OZ Minerals had AU$3.70m of debt, up from none a year ago. Click the image for more detail. But it also has AU$185.5m in cash to offset that, meaning it has AU$181.8m net cash.
A Look At OZ Minerals's Liabilities
Zooming in on the latest balance sheet data, we can see that OZ Minerals had liabilities of AU$221.7m due within 12 months and liabilities of AU$440.1m due beyond that. Offsetting these obligations, it had cash of AU$185.5m as well as receivables valued at AU$124.7m due within 12 months. So it has liabilities totalling AU$351.6m more than its cash and near-term receivables, combined.
Of course, OZ Minerals has a market capitalization of AU$2.91b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, OZ Minerals boasts net cash, so it's fair to say it does not have a heavy debt load!
It is just as well that OZ Minerals's load is not too heavy, because its EBIT was down 49% 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 OZ Minerals'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. OZ Minerals 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, OZ Minerals reported free cash flow worth 7.1% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
While OZ Minerals does have more liabilities than liquid assets, it also has net cash of AU$182m. So although we see some areas for improvement, we're not too worried about OZ Minerals's balance sheet. 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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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. Thank you for reading.