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.' 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. We note that Zimplats Holdings Limited (ASX:ZIM) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Zimplats Holdings

What Is Zimplats Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Zimplats Holdings had US$11.8m of debt, an increase on none, over one year. But it also has US$241.8m in cash to offset that, meaning it has US$230.0m net cash.

How Healthy Is Zimplats Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zimplats Holdings had liabilities of US$198.6m due within 12 months and liabilities of US$288.6m due beyond that. Offsetting these obligations, it had cash of US$241.8m as well as receivables valued at US$409.3m due within 12 months. So it can boast US$163.9m more liquid assets than total liabilities.

This surplus suggests that Zimplats Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Zimplats Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Zimplats Holdings grew its EBIT by 149% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Zimplats Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Zimplats Holdings 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. In the last three years, Zimplats Holdings's free cash flow amounted to 41% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Zimplats Holdings has US$230.0m in net cash and a decent-looking balance sheet. And we liked the look of last year's 149% year-on-year EBIT growth. So we don't think Zimplats Holdings's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example – Zimplats Holdings has 2 warning signs we think you should be aware of.

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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