Does Allkem (ASX:AKE) Have A Healthy Balance Sheet?

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. We note that Allkem Limited (ASX:AKE) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Allkem

How Much Debt Does Allkem Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Allkem had US$306.3m of debt, an increase on US$228.4m, over one year. However, because it has a cash reserve of US$258.3m, its net debt is less, at about US$48.0m.

A Look At Allkem's Liabilities

The latest balance sheet data shows that Allkem had liabilities of US$76.5m due within a year, and liabilities of US$547.1m falling due after that. On the other hand, it had cash of US$258.3m and US$23.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$341.8m.

Since publicly traded Allkem shares are worth a total of US$4.55b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, Allkem has virtually no net debt, so it's fair to say it does not have a heavy debt load!

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Allkem has a quite reasonable net debt to EBITDA multiple of 2.2, its interest cover seems weak, at 0.31. The main reason for this is that it has such high depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) In any case, it's safe to say the company has meaningful debt. We also note that Allkem improved its EBIT from a last year's loss to a positive US$4.7m. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Allkem can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Allkem burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Allkem's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Allkem stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. For example Allkem has 2 warning signs (and 1 which is potentially serious) we think you should know about.

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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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.