Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. 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. Like many other companies Lynas Rare Earths Limited (ASX:LYC) uses debt. But the more important question is: what risk does this debt create?
When is debt a problem?
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. 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. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we think about a company’s use of debt, we first look at cash and debt together.
See our latest analysis for Lynas Rare Earths
What is Lynas Rare Earths debt?
The image below, which you can click on for more details, shows that in December 2021, Lynas Rare Earths had a debt of 177.3 million Australian dollars, compared to 163.7 million Australian dollars in one year . However, his balance sheet shows he is holding A$674.2 million in cash, so he actually has A$496.9 million in net cash.
How strong is Lynas Rare Earths’ balance sheet?
We can see from the most recent balance sheet that Lynas Rare Earths had liabilities of A$121.4m due within a year, and liabilities of A$271.0m due beyond . On the other hand, it had cash of A$674.2 million and A$102.2 million of receivables due within a year. It can therefore boast liquid assets of A$384.0 million more than total Passives.
This short-term liquidity is a sign that Lynas Rare Earths could probably repay its debt easily, as its balance sheet is far from stretched. In short, Lynas Rare Earths has a clean cash flow, so it’s fair to say that she doesn’t have a lot of debt!
Even better, Lynas Rare Earths increased its EBIT by 1,762% last year, which is an impressive improvement. This boost will make paying off debt even easier in the future. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Lynas Rare Earths 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, while the taxman may love accounting profits, lenders only accept cash. Lynas Rare Earths may have net cash on the balance sheet, but it’s always interesting to see how well the company converts its earnings before interest and taxes (EBIT) into free cash flow, as this will influence both its need and its ability to manage debt. Over the past three years, Lynas Rare Earths has produced strong free cash flow equivalent to 73% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.
While we sympathize with investors who find debt a concern, you should bear in mind that Lynas Rare Earths has net cash of A$496.9 million, as well as more liquid assets than liabilities. . And we liked the look of EBIT growth of 1,762% YoY last year. So we don’t think Lynas Rare Earths’ use of debt is risky. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. For example – Lynas Rare Earths has 1 warning sign we think you should know.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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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.