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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Red River Resources Limited (ASX:RVR) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Red River Resources Carry?
As you can see below, at the end of December 2021, Red River Resources had AU$12.2m of debt, up from AU$1.03m a year ago. Click the image for more detail. But it also has AU$13.2m in cash to offset that, meaning it has AU$959.0k net cash.
A Look At Red River Resources' Liabilities
We can see from the most recent balance sheet that Red River Resources had liabilities of AU$27.8m falling due within a year, and liabilities of AU$17.5m due beyond that. Offsetting these obligations, it had cash of AU$13.2m as well as receivables valued at AU$5.63m due within 12 months. So its liabilities total AU$26.4m more than the combination of its cash and short-term receivables.
Red River Resources has a market capitalization of AU$119.2m, 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. Despite its noteworthy liabilities, Red River Resources boasts net cash, so it's fair to say it does not have a heavy debt load!
Shareholders should be aware that Red River Resources's EBIT was down 83% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Red River Resources 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 company can only pay off debt with cold hard cash, not accounting profits. Red River 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, Red River Resources saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
While Red River Resources does have more liabilities than liquid assets, it also has net cash of AU$959.0k. Despite its cash we think that Red River Resources seems to struggle to grow its EBIT, so we are wary of the stock. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Red River Resources has 1 warning sign we think you should be aware of.
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.