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.' 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. We note that Atlas Pearls Limited (ASX:ATP) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Atlas Pearls Carry?
The image below, which you can click on for greater detail, shows that Atlas Pearls had debt of AU$4.20m at the end of June 2021, a reduction from AU$4.52m over a year. On the flip side, it has AU$3.02m in cash leading to net debt of about AU$1.18m.
A Look At Atlas Pearls' Liabilities
According to the last reported balance sheet, Atlas Pearls had liabilities of AU$6.86m due within 12 months, and liabilities of AU$2.77m due beyond 12 months. Offsetting these obligations, it had cash of AU$3.02m as well as receivables valued at AU$526.4k due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$6.08m.
Atlas Pearls has a market capitalization of AU$11.0m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Atlas Pearls's net debt is only 0.24 times its EBITDA. And its EBIT easily covers its interest expense, being 10.6 times the size. So we're pretty relaxed about its super-conservative use of debt. Although Atlas Pearls made a loss at the EBIT level, last year, it was also good to see that it generated AU$4.7m in EBIT over the last twelve months. 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 if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Atlas Pearls produced sturdy free cash flow equating to 54% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Both Atlas Pearls's ability to handle its debt, based on its EBITDA, and its interest cover gave us comfort that it can handle its debt. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. Considering this range of data points, we think Atlas Pearls is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. To that end, you should learn about the 3 warning signs we've spotted with Atlas Pearls (including 2 which don't sit too well with us) .
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.
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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.
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