These 4 Measures Indicate That Allkem (ASX:AKE) Is Using Debt Reasonably Well

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. Importantly, Allkem Limited (ASX:AKE) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Our analysis indicates that AKE is potentially undervalued!

What Is Allkem's Debt?

The chart below, which you can click on for greater detail, shows that Allkem had US$313.1m in debt in June 2022; about the same as the year before. But on the other hand it also has US$663.5m in cash, leading to a US$350.4m net cash position.

How Strong Is Allkem's Balance Sheet?

We can see from the most recent balance sheet that Allkem had liabilities of US$222.5m falling due within a year, and liabilities of US$1.19b due beyond that. On the other hand, it had cash of US$663.5m and US$81.8m worth of receivables due within a year. So its liabilities total US$666.0m more than the combination of its cash and short-term receivables.

Since publicly traded Allkem shares are worth a total of US$5.66b, 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!

Better yet, Allkem grew its EBIT by 9,073% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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. In the last two years, Allkem created free cash flow amounting to 15% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

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$350.4m. And it impressed us with its EBIT growth of 9,073% over the last year. So we don't have any problem with Allkem's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Allkem is showing 1 warning sign in our investment analysis , you should know about...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.