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. Importantly, Base Resources Limited (ASX:BSE) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Base Resources

What Is Base Resources's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Base Resources had debt of US$24.5m, up from US$14.1m in one year. But it also has US$99.6m in cash to offset that, meaning it has US$75.1m net cash.

How Healthy Is Base Resources' Balance Sheet?

The latest balance sheet data shows that Base Resources had liabilities of US$90.2m due within a year, and liabilities of US$32.4m falling due after that. On the other hand, it had cash of US$99.6m and US$32.9m worth of receivables due within a year. So it can boast US$9.84m more liquid assets than total liabilities.

This short term liquidity is a sign that Base Resources could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Base Resources has more cash than debt is arguably a good indication that it can manage its debt safely.

But the other side of the story is that Base Resources saw its EBIT decline by 5.7% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Base Resources can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Base Resources has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Base Resources produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Base Resources has net cash of US$75.1m, as well as more liquid assets than liabilities. The cherry on top was that in converted 79% of that EBIT to free cash flow, bringing in US$75m. So is Base Resources's debt a risk? It doesn't seem so to us. 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. Be aware that Base Resources is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable…

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.

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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