Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. We can see that Nouvel Or inc. (TSE: NGD) uses debt in its business. But should shareholders be concerned about its use of debt?
When Is Debt a Problem?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
See our latest review for New Gold
How much debt does new gold carry?
You can click on the chart below for the historical numbers, but it shows New Gold owed US $ 490.1 million in debt as of June 2021, up from US $ 1.08 billion a year earlier. However, it has $ 203.9 million in cash offsetting that, which leads to net debt of around $ 286.2 million.
A look at New Gold’s liabilities
The latest balance sheet data shows New Gold had $ 172.4 million in liabilities due within one year, and $ 1.29 billion in liabilities due after that. In compensation for these obligations, it had cash of US $ 203.9 million as well as receivables valued at US $ 79.6 million due within 12 months. It therefore has liabilities totaling US $ 1.18 billion more than its cash and short-term receivables combined.
Since this deficit is actually greater than the company’s market cap of $ 1.04 billion, we think shareholders should really watch New Gold’s debt levels, like a parent watching their child. riding a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely that shareholders would suffer a significant dilution.
We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). Thus, we consider debt versus earnings with and without amortization charges.
While New Gold’s low debt-to-EBITDA ratio of 0.92 suggests only a modest use of debt, the fact that EBIT only covered interest expense 3.3 times last year makes us reflect. We therefore recommend that you keep a close eye on the impact of financing costs on the business. We also note that New Gold improved its EBIT from a loss last year to a positive amount of US $ 128 million. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether New Gold can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business needs free cash flow to repay its debts; accounting profits are not enough. It is therefore worth checking to what extent earnings before interest and taxes (EBIT) are backed by free cash flow. Over the past year, New Gold’s free cash flow has been 41% of its EBIT, less than we expected. It’s not great when it comes to paying down debt.
Our point of view
At first glance, New Gold’s interest coverage left us hesitant about the stock, and its total liability level was no more appealing than the lone restaurant empty on the busiest night of the year. But at least it manages its debt quite well, based on its EBITDA; it’s encouraging. Once we consider all of the above factors together it looks like New Gold’s debt makes it a bit risky. This isn’t necessarily a bad thing, but we would generally feel more comfortable with less leverage. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. To do this, you need to know the 1 warning sign we spotted with New Gold.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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