Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies First Resources Limited (SGX:EB5) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for First Resources

What Is First Resources's Net Debt?

As you can see below, First Resources had US$205.9m of debt at June 2024, down from US$251.1m a year prior. However, it also had US$102.9m in cash, and so its net debt is US$103.0m.

How Healthy Is First Resources' Balance Sheet?

We can see from the most recent balance sheet that First Resources had liabilities of US$222.1m falling due within a year, and liabilities of US$180.6m due beyond that. Offsetting these obligations, it had cash of US$102.9m as well as receivables valued at US$68.7m due within 12 months. So its liabilities total US$231.1m more than the combination of its cash and short-term receivables.

Since publicly traded First Resources shares are worth a total of US$1.76b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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's net debt is only 0.32 times its EBITDA. And its EBIT covers its interest expense a whopping 119 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for First Resources if management cannot prevent a repeat of the 27% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 First Resources can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Looking at the most recent three years, First Resources recorded free cash flow of 42% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Based on what we've seen First Resources is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about First Resources's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for First Resources that you should be aware of before investing here.