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.' 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. We can see that Pan American Silver Corp. (TSE:PAAS) does use debt in its business. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Pan American Silver's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Pan American Silver had US$20.8m of debt in March 2021, down from US$280.8m, one year before. But on the other hand it also has US$206.4m in cash, leading to a US$185.6m net cash position.
How Healthy Is Pan American Silver's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Pan American Silver had liabilities of US$324.8m due within 12 months and liabilities of US$454.5m due beyond that. On the other hand, it had cash of US$206.4m and US$139.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$433.8m.
Of course, Pan American Silver has a market capitalization of US$5.87b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Pan American Silver boasts net cash, so it's fair to say it does not have a heavy debt load!
Better yet, Pan American Silver grew its EBIT by 122% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Pan American Silver'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Pan American Silver 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 two years, Pan American Silver generated free cash flow amounting to a very robust 91% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Pan American Silver has US$185.6m in net cash. And it impressed us with free cash flow of US$207m, being 91% of its EBIT. So we don't think Pan American Silver's use of debt is risky. Another factor that would give us confidence in Pan American Silver would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly 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.
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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