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 Base Resources Limited (ASX:BSE) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Base Resources's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Base Resources had debt of US$18.9m, up from US$88.7 in one year. However, its balance sheet shows it holds US$39.2m in cash, so it actually has US$20.3m net cash.
How Strong Is Base Resources's Balance Sheet?
The latest balance sheet data shows that Base Resources had liabilities of US$68.6m due within a year, and liabilities of US$59.8m falling due after that. Offsetting these obligations, it had cash of US$39.2m as well as receivables valued at US$62.4m due within 12 months. So its liabilities total US$26.8m more than the combination of its cash and short-term receivables.
Given Base Resources has a market capitalization of US$188.1m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Base Resources also has more cash than debt, so we're pretty confident it can manage its debt safely.
While Base Resources doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. 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 Base Resources'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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Base Resources 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, Base Resources generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
While Base Resources does have more liabilities than liquid assets, it also has net cash of US$20.3m. The cherry on top was that in converted 82% of that EBIT to free cash flow, bringing in US$61m. So we don't have any problem with Base Resources's use of debt. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Base Resources insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
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.
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