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.' 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 First Resources Limited (SGX:EB5) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for First Resources

What Is First Resources's Net Debt?

The image below, which you can click on for greater detail, shows that First Resources had debt of US$347.8m at the end of June 2022, a reduction from US$408.9m over a year. On the flip side, it has US$243.6m in cash leading to net debt of about US$104.2m.

How Healthy Is First Resources' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that First Resources had liabilities of US$208.5m due within 12 months and liabilities of US$291.2m due beyond that. On the other hand, it had cash of US$243.6m and US$107.1m worth of receivables due within a year. So it has liabilities totalling US$149.0m more than its cash and near-term receivables, combined.

Of course, First Resources has a market capitalization of US$1.70b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

First Resources has a low net debt to EBITDA ratio of only 0.23. And its EBIT easily covers its interest expense, being 34.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that First Resources grew its EBIT by 103% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine First Resources'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, First Resources's free cash flow amounted to 48% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

First Resources's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, First Resources seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for First Resources (1 doesn't sit too well with us!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.