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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies TMAC Resources Inc. (TSE:TMR) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for TMAC Resources

What Is TMAC Resources's Debt?

You can click the graphic below for the historical numbers, but it shows that TMAC Resources had CA$151.7m of debt in March 2019, down from CA$200.0m, one year before. However, it does have CA$25.6m in cash offsetting this, leading to net debt of about CA$126.1m.

How Healthy Is TMAC Resources's Balance Sheet?

We can see from the most recent balance sheet that TMAC Resources had liabilities of CA$85.4m falling due within a year, and liabilities of CA$208.9m due beyond that. On the other hand, it had cash of CA$25.6m and CA$1.80m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$266.9m.

TMAC Resources has a market capitalization of CA$694.6m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While TMAC Resources has a quite reasonable net debt to EBITDA multiple of 1.9, its interest cover seems weak, at 0.43. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. Notably, TMAC Resources made a loss at the EBIT level, last year, but improved that to positive EBIT of CA$8.3m 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 TMAC 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, TMAC Resources burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both TMAC Resources's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its net debt to EBITDA is not so bad. Overall, we think it's fair to say that TMAC Resources has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Given our hesitation about the stock, it would be good to know if TMAC Resources insiders have sold any shares recently. You click here to find out if insiders have sold recently.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.