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 Resolute Mining Limited (ASX:RSG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Resolute Mining Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Resolute Mining had debt of AU$239.9m, up from AU$47.3m in one year. However, it also had AU$33.6m in cash, and so its net debt is AU$206.4m.
How Strong Is Resolute Mining's Balance Sheet?
According to the last reported balance sheet, Resolute Mining had liabilities of AU$262.7m due within 12 months, and liabilities of AU$258.1m due beyond 12 months. Offsetting this, it had AU$33.6m in cash and AU$75.4m in receivables that were due within 12 months. So it has liabilities totalling AU$411.9m more than its cash and near-term receivables, combined.
Resolute Mining has a market capitalization of AU$1.32b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Resolute Mining'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.
Over 12 months, Resolute Mining reported revenue of AU$527m, which is a gain of 18%. We usually like to see faster growth from unprofitable companies, but each to their own.
Over the last twelve months Resolute Mining produced an earnings before interest and tax (EBIT) loss. To be specific the EBIT loss came in at AU$3.8m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled AU$259m in negative free cash flow over the last twelve months. So in short it's a really risky stock. For riskier companies like Resolute Mining I always like to keep an eye on whether insiders are buying or selling. So click here if you want to find out for yourself.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.