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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Aurelia Metals Limited (ASX:AMI) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Aurelia Metals

What Is Aurelia Metals's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Aurelia Metals had debt of AU$41.8m, up from none in one year. However, its balance sheet shows it holds AU$105.8m in cash, so it actually has AU$63.9m net cash.

How Strong Is Aurelia Metals' Balance Sheet?

According to the last reported balance sheet, Aurelia Metals had liabilities of AU$112.9m due within 12 months, and liabilities of AU$137.4m due beyond 12 months. On the other hand, it had cash of AU$105.8m and AU$18.5m worth of receivables due within a year. So its liabilities total AU$126.0m more than the combination of its cash and short-term receivables.

Aurelia Metals has a market capitalization of AU$469.0m, 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. While it does have liabilities worth noting, Aurelia Metals also has more cash than debt, so we're pretty confident it can manage its debt safely.

Even more impressive was the fact that Aurelia Metals grew its EBIT by 125% over twelve months. That boost will make it even easier to pay down debt going forward. 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 Aurelia Metals'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Aurelia Metals 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. Over the last three years, Aurelia Metals recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing up

While Aurelia Metals does have more liabilities than liquid assets, it also has net cash of AU$63.9m. And it impressed us with free cash flow of AU$70m, being 83% of its EBIT. So is Aurelia Metals's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Aurelia Metals you should know about.

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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