Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that PrairieSky Royalty Ltd. (TSE:PSK) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is PrairieSky Royalty's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 PrairieSky Royalty had CA$4.90m of debt, an increase on CA$500.0k, over one year. However, its balance sheet shows it holds CA$10.0m in cash, so it actually has CA$5.10m net cash.
How Healthy Is PrairieSky Royalty's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that PrairieSky Royalty had liabilities of CA$38.1m due within 12 months and liabilities of CA$193.8m due beyond that. Offsetting this, it had CA$10.0m in cash and CA$29.7m in receivables that were due within 12 months. So it has liabilities totalling CA$192.2m more than its cash and near-term receivables, combined.
Given PrairieSky Royalty has a market capitalization of CA$3.07b, 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. Despite its noteworthy liabilities, PrairieSky Royalty boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for PrairieSky Royalty if management cannot prevent a repeat of the 39% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine PrairieSky Royalty'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. PrairieSky Royalty 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. Over the most recent three years, PrairieSky Royalty recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While it is always sensible to look at a company's total liabilities, it is very reassuring that PrairieSky Royalty has CA$5.10m in net cash. And it impressed us with free cash flow of CA$201m, being 73% of its EBIT. So we are not troubled with PrairieSky Royalty's debt use. We'd be motivated to research the stock further if we found out that PrairieSky Royalty insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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If you spot an error that warrants correction, please contact the editor at [email protected]. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.