Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Above all, Evolution Mining Limited (ASX:EVN) is in debt. But should shareholders worry about its use of debt?
What risk does debt carry?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Evolution Mining
What is Evolution Mining’s net debt?
As you can see below, at the end of June 2022, Evolution Mining had A$1.84 billion in debt, up from A$611.2 million a year ago. Click on the image for more details. However, he has A$572.4 million in cash to offset this, resulting in a net debt of around A$1.27 billion.
How healthy is Evolution Mining’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Evolution Mining had liabilities of A$861.9 million due within 12 months and liabilities of A$2.51 billion due beyond. On the other hand, it had cash of A$572.4 million and A$174.2 million of receivables due within a year. It therefore has liabilities totaling A$2.63 billion more than its cash and short-term receivables, combined.
This deficit is considerable compared to its market capitalization of 4.18 billion Australian dollars, so it suggests that shareholders monitor the use of debt by Evolution Mining. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
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.
With a net debt of only 1.4 times EBITDA, Evolution Mining is arguably quite conservative. And this view is supported by strong interest coverage, with EBIT amounting to 9.4 times interest expense over the past year. On the other hand, Evolution Mining’s EBIT fell 19% from a year ago. If this rate of decline in profits continues, the company could find itself in a delicate situation. 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 Evolution Mining can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Evolution Mining has recorded free cash flow of 63% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
Evolution Mining’s struggle to increase EBIT made us doubt the strength of its balance sheet, but other data points we considered were relatively rewarding. In particular, his interest coverage was invigorating. We think Evolution Mining’s debt makes it a bit risky, after looking at the aforementioned data points together. This isn’t necessarily a bad thing, since leverage can increase return on equity, but it is something to be aware of. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. For example – Evolution Mining has 1 warning sign we think you should know.
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.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
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.
Calculation of discounted cash flows for each share
Simply Wall St performs a detailed calculation of discounted cash flow every 6 hours for every stock in the market, so if you want to find the intrinsic value of any company, just search here. It’s free.