Warren Buffett said: “Volatility is far from synonymous with risk. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We can see that Sierra Metals Inc. (TSE:SMT) uses debt in its business. But should shareholders worry about its use of debt?
When is debt a problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. 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. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Sierra Metals
How much debt does Sierra Metals have?
The image below, which you can click for more details, shows Sierra Metals had $86.9 million in debt at the end of September 2021, a reduction from $99.4 million year-over-year. However, since he has a cash reserve of $58.3 million, his net debt is less, at around $28.6 million.
A Look at Sierra Metals Liabilities
According to the last published balance sheet, Sierra Metals had liabilities of $87.2 million due within 12 months and liabilities of $113.4 million due beyond 12 months. On the other hand, it had a cash position of 58.3 million dollars and 36.1 million dollars of receivables at less than one year. Thus, its liabilities outweigh the sum of its cash and receivables (current) by $106.3 million.
This shortfall is not that bad as Sierra Metals is worth $188.1 million and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. However, it is always worth taking a close look at your ability to repay debt.
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 ).
Sierra Metals’ net debt is only 0.27 times its EBITDA. And its EBIT covers its interest charges 18.6 times. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. On top of that, Sierra Metals has grown its EBIT by 41% over the last twelve months, and this growth will make it easier to manage its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Sierra Metals 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.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Sierra Metals has reported free cash flow of 18% of its EBIT, which is really quite low. For us, such a low cash conversion creates a bit of paranoia about the ability to extinguish the debt.
Our point of view
Sierra Metals’ interest coverage suggests they can manage their debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. But, on a darker note, we are a bit concerned about its conversion of EBIT into free cash flow. Looking at all of the aforementioned factors together, it seems to us that Sierra Metals can manage its debt quite comfortably. Of course, while this leverage can improve return on equity, it comes with more risk, so it’s worth keeping an eye out for. 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. For example, we have identified 3 warning signs for Sierra Metals of which you should be aware.
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.
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