Atlas Pearls (ASX:ATP) Seems To Use Debt Quite Sensibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Atlas Pearls Limited (ASX:ATP) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Atlas Pearls

How Much Debt Does Atlas Pearls Carry?

You can click the graphic below for the historical numbers, but it shows that Atlas Pearls had AU$2.62m of debt in December 2021, down from AU$6.92m, one year before. But on the other hand it also has AU$4.42m in cash, leading to a AU$1.80m net cash position.

How Healthy Is Atlas Pearls' Balance Sheet?

The latest balance sheet data shows that Atlas Pearls had liabilities of AU$7.28m due within a year, and liabilities of AU$375.1k falling due after that. Offsetting these obligations, it had cash of AU$4.42m as well as receivables valued at AU$1.09m due within 12 months. So its liabilities total AU$2.14m more than the combination of its cash and short-term receivables.

Of course, Atlas Pearls has a market capitalization of AU$23.4m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Atlas Pearls boasts net cash, so it's fair to say it does not have a heavy debt load!

It was also good to see that despite losing money on the EBIT line last year, Atlas Pearls turned things around in the last 12 months, delivering and EBIT of AU$8.5m. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Atlas Pearls will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Atlas Pearls 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. Over the last year, Atlas Pearls recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing up

We could understand if investors are concerned about Atlas Pearls's liabilities, but we can be reassured by the fact it has has net cash of AU$1.80m. The cherry on top was that in converted 81% of that EBIT to free cash flow, bringing in AU$6.9m. So we don't think Atlas Pearls's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Atlas Pearls (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.