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These 4 Measures Indicate That Champion Iron (ASX:CIA) Is Using Debt Reasonably Well

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Champion Iron Limited (ASX:CIA) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Champion Iron

What Is Champion Iron's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Champion Iron had CA$264.3m of debt, an increase on CA$225.6m, over one year. But it also has CA$347.5m in cash to offset that, meaning it has CA$83.2m net cash.

debt-equity-history-analysis
debt-equity-history-analysis

How Strong Is Champion Iron's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Champion Iron had liabilities of CA$179.7m due within 12 months and liabilities of CA$366.8m due beyond that. Offsetting these obligations, it had cash of CA$347.5m as well as receivables valued at CA$84.5m due within 12 months. So it has liabilities totalling CA$114.6m more than its cash and near-term receivables, combined.

Given Champion Iron has a market capitalization of CA$1.17b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Champion Iron also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Champion Iron if management cannot prevent a repeat of the 26% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Champion Iron's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Champion Iron may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent two years, Champion Iron recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Champion Iron has CA$83.2m in net cash. So we are not troubled with Champion Iron's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 5 warning signs with Champion Iron (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

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

This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

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