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.' 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 Karora Resources Inc. (TSE:KRR) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Karora Resources's Debt?
You can click the graphic below for the historical numbers, but it shows that Karora Resources had CA$32.7m of debt in March 2022, down from CA$35.0m, one year before. But on the other hand it also has CA$81.0m in cash, leading to a CA$48.3m net cash position.
A Look At Karora Resources' Liabilities
Zooming in on the latest balance sheet data, we can see that Karora Resources had liabilities of CA$72.8m due within 12 months and liabilities of CA$114.7m due beyond that. Offsetting these obligations, it had cash of CA$81.0m as well as receivables valued at CA$7.27m due within 12 months. So it has liabilities totalling CA$99.2m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Karora Resources is worth CA$455.1m, and thus could probably raise enough capital to shore up 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. Despite its noteworthy liabilities, Karora Resources boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, Karora Resources's EBIT dived 15%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Karora Resources'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Karora Resources 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, Karora Resources reported free cash flow worth 18% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Although Karora Resources's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CA$48.3m. So while Karora Resources does not have a great balance sheet, it's certainly not too bad. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Karora Resources that you should be aware of before investing here.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
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