Legendary fund manager Li Lu (who supported Charlie Munger) once said, “The biggest investment risk isn’t price volatility, but whether you’ll suffer a permanent loss of capital.” It seems the smart money knows that debt – which usually accompanies bankruptcies – is a very important factor when assessing how risky a company is. As with many other companies Kinross Gold Corporation (TSE:K) takes advantage of debt. But should shareholders be concerned about using debt?
When is debt dangerous?
Debt helps a company until the company struggles to pay it off, either with new capital or free cash flow. When things go really bad, the lenders can take control of the company. However, a more common (but still painful) scenario is that it needs to raise new equity at a low price, permanently diluting shareholders. Of course, many companies use debt to finance growth, with no negative consequences. The first thing to do when considering how much debt a company uses is to look at its cash and debt together.
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What is Kinross Gold’s fault?
As you can see below, Kinross Gold was in debt of USD 1.93 billion in March 2021, down from USD 2.49 billion a year earlier. However, since it has a cash reserve of US$1.08 billion, its net debt is less, at approximately US$840.7 million.
A Look at Kinross Gold’s Commitments
If we zoom in on the most recent balance sheet data, we can see that Kinross Gold had liabilities of $1.07 billion due within 12 months and $2.94 billion thereafter. To offset these obligations, it had $1.08 billion in cash and $80.2 million in receivables to be paid within 12 months. It thus has liabilities totaling US$2.85 billion more than its cash and short-term receivables combined.
Kinross Gold has a market cap of US$9.86 billion, so it could very likely raise money to improve its balance sheet, if the need arises. However, it’s still worth looking closely at debt repayment ability.
We use two main ratios to inform us of debt levels relative to income. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times earnings before interest and tax (EBIT) will cover interest costs (or interest coverage for short). So we consider debt in relation to earnings, both with and without depreciation and amortization costs.
Kinross Gold has a low net debt-to-EBITDA ratio of just 0.39. And his EBIT covers his interest costs a whopping 22.7 times. So we’re pretty relaxed about the super conservative use of debt. In addition, we are pleased to report that Kinross Gold has increased its EBIT by 99%, reducing the specter of future debt repayments. The balance sheet is clearly the area to focus on when analyzing debt. But it is mainly future income that will determine Kinross Gold’s ability to maintain a healthy balance sheet in the future. So if you’re focused on the future, check this out free Analyst earnings forecast report.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t do it. So we need to see clearly whether that EBIT leads to a corresponding free cash flow. Over the past three years, Kinross Gold’s free cash flow has been 30% of its EBIT, less than we expected. That weak cash conversion makes it harder to deal with debt.
Fortunately, Kinross Gold’s impressive interest coverage implies that it has the upper hand over its debt. But frankly, we think the conversion from EBIT to free cash flow undermines this impression a bit. Taking all this data into account, it seems to us that Kinross Gold is taking a fairly sensible approach to debt. That means they take a little more risk, hoping to increase shareholder returns. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside within the balance sheet – far from it. Be aware of Kinross Gold is shown 2 warning signs in our investment analysis , and 1 of them can’t be ignored…
If you are interested in investing in companies that can make profits without debt, check this out free list of growing companies with net cash on the balance sheet.
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