Legendary fund manager Li Lu (who Charlie Munger supported) once said, âThe biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Like many other companies Victoria Gold Corp. (TSE: VGCX) uses debt. But the most important question is: what risk does this debt create?
When Is Debt a Problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. If things really go wrong, lenders can take over the business. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is Victoria Gold’s net debt?
As you can see below, Victoria Gold had C $ 251.9 million in debt in June 2021, up from C $ 289.6 million the year before. However, given that it has a cash reserve of C $ 19.7 million, its net debt is less, at approximately C $ 232.2 million.
Is Victoria Gold’s track record healthy?
The most recent balance sheet shows Victoria Gold had a liability of C $ 102.3 million maturing within one year and a liability of C $ 285.6 million beyond. On the other hand, he had C $ 19.7 million in cash and C $ 1.12 million in receivables due within one year. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by C $ 367.2 million.
Victoria Gold has a market cap of C $ 871.3 million, so she could most likely raise funds to improve her balance sheet, should the need arise. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While Victoria Gold’s low debt-to-EBITDA ratio of 1.3 suggests only a modest use of debt, the fact that EBIT only covered interest expense 6.4 times last year makes us reflect. We therefore recommend that you keep a close eye on the impact of financing costs on the business. It was also good to see that despite losing money on the EBIT line last year, Victoria Gold has been a game changer over the past 12 months, delivering EBIT of C $ 126 million. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Victoria Gold can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business can only pay off its debts with hard cash, not with book profits. It is therefore important to check to what extent its earnings before interest and taxes (EBIT) are converted into actual free cash flow. Over the past year, Victoria Gold has created free cash flow of 9.9% of its EBIT, a performance without interest. For us, the conversion to cash that elicits a bit of paranoia is the ability to extinguish debt.
Our point of view
Victoria Gold’s conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we took into account cast it in a better light. But on the bright side, its ability to manage its debt, based on its EBITDA, is not at all shabby. Looking at all the angles mentioned above, it seems to us that Victoria Gold is a somewhat risky investment because of its debt. Not all risks are bad, as they can increase stock price returns if they are profitable, but this risk of leverage is worth keeping in mind. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 3 warning signs for Victoria Gold which you should know before investing here.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
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