Here’s why Lundin Gold (TSE:LUG) can manage debt responsibly

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David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We can see that Lundin Gold Inc. (TSE:LUG) uses debt in its business. But the more important question is: what risk does this debt create?

When is debt dangerous?

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. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first thing to do when considering how much debt a business has is to look at its cash and debt together.

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How much debt does Lundin Gold have?

You can click on the chart below for historical numbers, but it shows Lundin Gold had $645.7 million in debt in June 2022, up from $772.4 million a year prior. On the other hand, it has $301.0 million in cash, resulting in a net debt of approximately $344.7 million.

TSX:LUG Debt to Equity History September 27, 2022

How strong is Lundin Gold’s balance sheet?

We can see from the most recent balance sheet that Lundin Gold had liabilities of US$315.4 million due in one year, and liabilities of US$438.4 million due beyond. In return, it had $301.0 million in cash and $143.9 million in receivables due within 12 months. It therefore has liabilities totaling $308.9 million more than its cash and short-term receivables, combined.

While that might sound like a lot, it’s not too bad since Lundin Gold has a market capitalization of $1.52 billion, so it could likely bolster its balance sheet by raising capital if needed. 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). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).

Lundin Gold has net debt of just 0.76 times EBITDA, indicating that it is certainly not an imprudent borrower. And this view is supported by strong interest coverage, with EBIT amounting to 9.6 times interest expense over the past year. Fortunately, Lundin Gold has grown its EBIT by 5.7% over the past year, making this debt even more manageable. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Lundin Gold can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, a business needs free cash flow to pay off its debts; book profits are not enough. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past two years, Lundin Gold has generated free cash flow of a very strong 93% of its EBIT, more than expected. This puts him in a very strong position to pay off the debt.

Our point of view

Lundin Gold’s conversion of EBIT to free cash flow suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. And the good news doesn’t end there, because its interesting cover also reinforces this impression! Zooming out, Lundin Gold appears to be using debt quite sensibly; and that gets the green light from us. After all, reasonable leverage can increase return on equity. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, we have identified 2 warning signs for Lundin Gold (1 is significant) which you should be aware of.

If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.

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.

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