Health Check: How Prudently Does Lucapa Diamond (ASX:LOM) Use Debt?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Lucapa Diamond Company Limited (ASX:LOM) makes use of debt. But the more important question is: how much risk is that debt creating?

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 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Lucapa Diamond

What Is Lucapa Diamond's Debt?

As you can see below, Lucapa Diamond had US$6.32m of debt at December 2022, down from US$18.4m a year prior. However, its balance sheet shows it holds US$6.91m in cash, so it actually has US$582.0k net cash.

A Look At Lucapa Diamond's Liabilities

The latest balance sheet data shows that Lucapa Diamond had liabilities of US$14.3m due within a year, and liabilities of US$2.39m falling due after that. Offsetting this, it had US$6.91m in cash and US$5.29m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.47m.

Since publicly traded Lucapa Diamond shares are worth a total of US$34.7m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Lucapa Diamond also has more cash than debt, so we're pretty confident it can manage its debt safely. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Lucapa Diamond's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

In the last year Lucapa Diamond had a loss before interest and tax, and actually shrunk its revenue by 13%, to US$23m. We would much prefer see growth.

So How Risky Is Lucapa Diamond?

Statistically speaking companies that lose money are riskier than those that make money. And in the last year Lucapa Diamond had an earnings before interest and tax (EBIT) loss, truth be told. And over the same period it saw negative free cash outflow of US$12m and booked a US$10m accounting loss. Given it only has net cash of US$582.0k, the company may need to raise more capital if it doesn't reach break-even soon. Summing up, we're a little skeptical of this one, as it seems fairly risky in the absence of free cashflow. 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 learn about the 3 warning signs we've spotted with Lucapa Diamond (including 2 which are concerning) .

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.