We Think G8 Education (ASX:GEM) Is Taking Some Risk With Its Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 G8 Education Limited (ASX:GEM) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for G8 Education

How Much Debt Does G8 Education Carry?

The image below, which you can click on for greater detail, shows that G8 Education had debt of AU$295.1m at the end of December 2020, a reduction from AU$387.8m over a year. However, its balance sheet shows it holds AU$317.7m in cash, so it actually has AU$22.5m net cash.

A Look At G8 Education's Liabilities

The latest balance sheet data shows that G8 Education had liabilities of AU$275.8m due within a year, and liabilities of AU$923.8m falling due after that. Offsetting these obligations, it had cash of AU$317.7m as well as receivables valued at AU$17.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$864.5m.

This is a mountain of leverage relative to its market capitalization of AU$894.0m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, G8 Education boasts net cash, so it's fair to say it does not have a heavy debt load!

Unfortunately, G8 Education's EBIT flopped 16% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine G8 Education's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While G8 Education has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, G8 Education recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing up

Although G8 Education's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$22.5m. And it impressed us with free cash flow of AU$163m, being 88% of its EBIT. So although we see some areas for improvement, we're not too worried about G8 Education's balance sheet. 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. To that end, you should be aware of the 1 warning sign we've spotted with G8 Education .

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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