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 Majestic Gold Corp. (CVE:MJS) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Majestic Gold's Debt?
As you can see below, Majestic Gold had US$4.71m of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has US$34.9m in cash, leading to a US$30.2m net cash position.
A Look At Majestic Gold's Liabilities
According to the last reported balance sheet, Majestic Gold had liabilities of US$24.8m due within 12 months, and liabilities of US$10.5m due beyond 12 months. Offsetting these obligations, it had cash of US$34.9m as well as receivables valued at US$115.9k due within 12 months. So these liquid assets roughly match the total liabilities.
Having regard to Majestic Gold's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$50.2m company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, Majestic Gold also has more cash than debt, so we're pretty confident it can manage its debt safely.
The modesty of its debt load may become crucial for Majestic Gold if management cannot prevent a repeat of the 29% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Majestic Gold will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Majestic Gold 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. During the last three years, Majestic Gold produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Majestic Gold has US$30.2m in net cash. The cherry on top was that in converted 67% of that EBIT to free cash flow, bringing in US$6.5m. So we don't have any problem with Majestic Gold's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Majestic Gold you should know about.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.