Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We can see that Emerald Resources NL (ASX:EMR) uses debt in its business. But does this debt worry shareholders?

Why is debt risky?

Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we look at debt levels, we first consider cash and debt levels, together.

Check out our latest analysis for Emerald Resources

What is Emerald Resources’ net debt?

As you can see below, at the end of December 2021, Emerald Resources had A$99.1 million in debt, up from A$78.2 million a year ago. Click on the image for more details. However, he has A$18.1 million in cash to offset this, resulting in a net debt of around A$81.1 million.

A Look at Emerald Resources Liabilities

According to the latest published balance sheet, Emerald Resources had liabilities of A$72.6 million due within 12 months and liabilities of A$112.7 million due beyond 12 months. In compensation for these obligations, it had cash of 18.1 million Australian dollars as well as receivables valued at 9.38 million Australian dollars maturing within 12 months. It therefore has liabilities totaling A$157.8 million more than its cash and short-term receivables, combined.

This shortfall is not that bad as Emerald Resources is worth A$690.5 million and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

Emerald Resources’ debt is 3.5 times its EBITDA, and its EBIT covers its interest expense 2.9 times. Taken together, this implies that, while we wouldn’t like to see debt levels increase, we think he can manage his current leverage. A redeeming factor for Emerald Resources is that it has turned last year’s EBIT loss into an A$11 million gain, over the past twelve months. The balance sheet is clearly the area to focus on when analyzing debt. But it is the earnings of Emerald Resources that will influence the balance sheet in the future. So, if you want to know more about its earnings, it may be worth checking out this graph of its long-term trend.

Finally, while the taxman may love accounting profits, lenders only accept cash. It is therefore important to check how much of its earnings before interest and taxes (EBIT) converts into actual free cash flow. Over the past year, Emerald Resources has burned a lot of cash. While this may be the result of spending for growth, it makes debt much riskier.

Our point of view

Reflecting on Emerald Resources’ attempt to convert EBIT to free cash flow, we are certainly not enthusiastic. But at least his total passive level isn’t that bad. Once we consider all of the above factors together, it seems to us that Emerald Resources’ debt makes it a bit risky. This isn’t necessarily a bad thing, but we would generally feel more comfortable with less leverage. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. We have identified 3 warning signs with Emerald Resources (at least 2 of which we don’t like too much), and understanding them should be part of your investment process.

Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.