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 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 Atlas Pearls Ltd (ASX:ATP) makes use of debt. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Atlas Pearls's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 Atlas Pearls had AU$6.92m of debt, an increase on AU$5.56m, over one year. On the flip side, it has AU$2.04m in cash leading to net debt of about AU$4.88m.
How Strong Is Atlas Pearls' Balance Sheet?
According to the last reported balance sheet, Atlas Pearls had liabilities of AU$7.85m due within 12 months, and liabilities of AU$2.78m due beyond 12 months. On the other hand, it had cash of AU$2.04m and AU$596.5k worth of receivables due within a year. So its liabilities total AU$7.98m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's AU$6.37m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. 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.
Over 12 months, Atlas Pearls made a loss at the EBIT level, and saw its revenue drop to AU$13m, which is a fall of 27%. To be frank that doesn't bode well.
Not only did Atlas Pearls's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Its EBIT loss was a whopping AU$4.7m. Considering that alongside the liabilities mentioned above make us nervous about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it burned through AU$2.0m in negative free cash flow over the last year. So suffice it to say we consider the stock to be risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Atlas Pearls (3 are potentially serious) you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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