Is Allkem (ASX:AKE) Using Too Much 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Allkem Limited (ASX:AKE) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

View our latest analysis for Allkem

How Much Debt Does Allkem Carry?

As you can see below, at the end of December 2021, Allkem had US$333.5m of debt, up from US$251.0m a year ago. Click the image for more detail. But it also has US$449.8m in cash to offset that, meaning it has US$116.3m net cash.

How Strong Is Allkem's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Allkem had liabilities of US$132.2m due within 12 months and liabilities of US$1.15b due beyond that. Offsetting this, it had US$449.8m in cash and US$31.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$799.2m.

Since publicly traded Allkem shares are worth a total of US$5.38b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Allkem boasts net cash, so it's fair to say it does not have a heavy debt load!

We also note that Allkem improved its EBIT from a last year's loss to a positive US$69m. There's no doubt that we learn most about debt from the balance sheet. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Allkem may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, Allkem saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing up

Although Allkem's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$116.3m. So while Allkem does not have a great balance sheet, it's certainly not too bad. 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. For example - Allkem has 1 warning sign we think 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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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.