Is Atlas Pearls (ASX:ATP) Using Debt In A Risky Way?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Atlas Pearls Ltd (ASX:ATP) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Atlas Pearls

What Is Atlas Pearls's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Atlas Pearls had debt of AU$6.92m, up from AU$5.56m in one year. However, because it has a cash reserve of AU$2.04m, its net debt is less, at about AU$4.88m.

How Healthy 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. Offsetting these obligations, it had cash of AU$2.04m as well as receivables valued at AU$596.5k due within 12 months. So its liabilities total AU$7.98m more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the AU$4.67m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Atlas Pearls would probably need a major re-capitalization if its creditors were to demand repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is Atlas Pearls's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

In the last year Atlas Pearls had a loss before interest and tax, and actually shrunk its revenue by 27%, to AU$13m. That makes us nervous, to say the least.

Caveat Emptor

While Atlas Pearls's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable AU$5.2m at the EBIT level. 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 had negative free cash flow of AU$2.0m over the last twelve months. So suffice it to say we consider the stock to be risky. 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. To that end, you should learn about the 4 warning signs we've spotted with Atlas Pearls (including 3 which are significant) .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. 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.
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