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.' 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 Century Aluminum Company (NASDAQ:CENX) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Century Aluminum's Debt?

As you can see below, Century Aluminum had US$485.9m of debt at September 2024, down from US$512.0m a year prior. However, it does have US$32.6m in cash offsetting this, leading to net debt of about US$453.3m.

How Strong Is Century Aluminum's Balance Sheet?

According to the last reported balance sheet, Century Aluminum had liabilities of US$472.3m due within 12 months, and liabilities of US$796.1m due beyond 12 months. Offsetting these obligations, it had cash of US$32.6m as well as receivables valued at US$205.7m due within 12 months. So its liabilities total US$1.03b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Century Aluminum has a market capitalization of US$2.13b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Century Aluminum's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 2.7 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. One redeeming factor for Century Aluminum is that it turned last year's EBIT loss into a gain of US$101m, over 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 Century Aluminum 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Considering the last year, Century Aluminum actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Mulling over Century Aluminum's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its EBIT growth rate is not so bad. Looking at the bigger picture, it seems clear to us that Century Aluminum's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Century Aluminum has 3 warning signs we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.