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. We note that Gem Diamonds Limited (LON:GEMD) does have debt on its balance sheet. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
Check out our latest analysis for Gem Diamonds
The image below, which you can click on for greater detail, shows that Gem Diamonds had debt of US$11.9m at the end of June 2022, a reduction from US$14.7m over a year. However, it does have US$24.2m in cash offsetting this, leading to net cash of US$12.3m.
According to the last reported balance sheet, Gem Diamonds had liabilities of US$25.6m due within 12 months, and liabilities of US$114.4m due beyond 12 months. On the other hand, it had cash of US$24.2m and US$3.79m worth of receivables due within a year. So it has liabilities totalling US$112.0m more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$48.6m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Gem Diamonds would probably need a major re-capitalization if its creditors were to demand repayment. Given that Gem Diamonds has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
It is just as well that Gem Diamonds's load is not too heavy, because its EBIT was down 51% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Gem Diamonds 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. Gem Diamonds may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Gem Diamonds recorded free cash flow of 37% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Although Gem Diamonds's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$12.3m. Despite the cash, we do find Gem Diamonds's level of total liabilities concerning, so we're not particularly comfortable with the stock. 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. We've identified 4 warning signs with Gem Diamonds , and understanding them should be part of your investment process.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
Find out whether Gem Diamonds is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.
Simply Wall St's Editorial Team provides unbiased, factual reporting on global stocks using in-depth fundamental analysis.
Find out more about our editorial guidelines and team.
Gem Diamonds Limited operates diamond mines.
The Snowflake is a visual investment summary with the score of each axis being calculated by 6 checks in 5 areas.
Read more about these checks in the individual report sections or in our analysis model.
Undervalued with excellent balance sheet and pays a dividend.
Simply Wall St's Editorial Team provides unbiased, factual reporting on global stocks using in-depth fundamental analysis.
Find out more about our editorial guidelines and team.
Gem Diamonds Limited operates diamond mines.
The Snowflake is a visual investment summary with the score of each axis being calculated by 6 checks in 5 areas.
Read more about these checks in the individual report sections or in our analysis model.
Undervalued with excellent balance sheet and pays a dividend.
Simply Wall Street Pty Ltd (ACN 600 056 611), is a Corporate Authorised Representative (Authorised Representative Number: 467183) of Sanlam Private Wealth Pty Ltd (AFSL No. 337927). Any advice contained in this website is general advice only and has been prepared without considering your objectives, financial situation or needs. You should not rely on any advice and/or information contained in this website and before making any investment decision we recommend that you consider whether it is appropriate for your situation and seek appropriate financial, taxation and legal advice. Please read our Financial Services Guide before deciding whether to obtain financial services from us.
About Author
