The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Golden Agri-Resources Ltd (SGX:E5H) does carry debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Golden Agri-Resources

What Is Golden Agri-Resources's Debt?

The chart below, which you can click on for greater detail, shows that Golden Agri-Resources had US$3.27b in debt in December 2021; about the same as the year before. However, because it has a cash reserve of US$535.1m, its net debt is less, at about US$2.73b.

How Strong Is Golden Agri-Resources' Balance Sheet?

According to the last reported balance sheet, Golden Agri-Resources had liabilities of US$2.93b due within 12 months, and liabilities of US$1.78b due beyond 12 months. Offsetting this, it had US$535.1m in cash and US$917.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.26b.

Given this deficit is actually higher than the company's market capitalization of US$3.03b, we think shareholders really should watch Golden Agri-Resources's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Golden Agri-Resources's net debt is sitting at a very reasonable 2.5 times its EBITDA, while its EBIT covered its interest expense just 5.4 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Pleasingly, Golden Agri-Resources is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 121% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Golden Agri-Resources can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Golden Agri-Resources produced sturdy free cash flow equating to 75% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both Golden Agri-Resources's ability to to grow its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think Golden Agri-Resources is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. We've identified 4 warning signs with Golden Agri-Resources (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.

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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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.