Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Base Resources Limited (ASX:BSE) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Base Resources Carry?
The image below, which you can click on for greater detail, shows that at June 2020 Base Resources had debt of US$73.8m, up from US$18.9m in one year. But it also has US$162.6m in cash to offset that, meaning it has US$88.7m net cash.
A Look At Base Resources's Liabilities
Zooming in on the latest balance sheet data, we can see that Base Resources had liabilities of US$88.3m due within 12 months and liabilities of US$83.4m due beyond that. Offsetting these obligations, it had cash of US$162.6m as well as receivables valued at US$46.6m due within 12 months. So it actually has US$37.5m more liquid assets than total liabilities.
This surplus suggests that Base Resources is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, Base Resources boasts net cash, so it's fair to say it does not have a heavy debt load!
But the bad news is that Base Resources has seen its EBIT plunge 14% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. 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 company can only pay off debt with cold hard cash, not accounting profits. Base 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 most recent three years, Base Resources recorded free cash flow worth 80% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to investigate a company's debt, in this case Base Resources has US$88.7m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of US$72m, being 80% of its EBIT. So we don't think Base Resources's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Base Resources is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored…
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.
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. 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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