Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Iluka Resources Limited (ASX:ILU) makes use of debt. But the real question is whether this debt is making the company risky.

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Iluka Resources

What Is Iluka Resources's Debt?

As you can see below, Iluka Resources had AU$36.9m of debt at December 2020, down from AU$54.0m a year prior. However, it does have AU$87.1m in cash offsetting this, leading to net cash of AU$50.2m.

How Strong Is Iluka Resources' Balance Sheet?

According to the last reported balance sheet, Iluka Resources had liabilities of AU$261.2m due within 12 months, and liabilities of AU$810.4m due beyond 12 months. Offsetting this, it had AU$87.1m in cash and AU$81.6m in receivables that were due within 12 months. So its liabilities total AU$902.9m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Iluka Resources has a market capitalization of AU$3.43b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Iluka Resources also has more cash than debt, so we're pretty confident it can manage its debt safely.

It is just as well that Iluka Resources's load is not too heavy, because its EBIT was down 46% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Iluka Resources's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Iluka Resources 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 three years, Iluka Resources recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing up

Although Iluka Resources's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$50.2m. So we are not troubled with Iluka Resources's debt use. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Iluka Resources insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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