Here's Why Lucapa Diamond (ASX:LOM) Can Afford Some Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Lucapa Diamond Company Limited (ASX:LOM) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.

Check out our latest analysis for Lucapa Diamond

What Is Lucapa Diamond's Debt?

As you can see below, Lucapa Diamond had US$20.7m of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$12.3m in cash leading to net debt of about US$8.41m.

A Look At Lucapa Diamond's Liabilities

Zooming in on the latest balance sheet data, we can see that Lucapa Diamond had liabilities of US$18.5m due within 12 months and liabilities of US$10.5m due beyond that. Offsetting these obligations, it had cash of US$12.3m as well as receivables valued at US$3.15m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$13.5m.

This deficit isn't so bad because Lucapa Diamond is worth US$63.4m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Lucapa Diamond will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

In the last year Lucapa Diamond wasn't profitable at an EBIT level, but managed to grow its revenue by 28%, to US$17m. Shareholders probably have their fingers crossed that it can grow its way to profits.

Caveat Emptor

Despite the top line growth, Lucapa Diamond still had an earnings before interest and tax (EBIT) loss over the last year. To be specific the EBIT loss came in at US$682k. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. However, it doesn't help that it burned through US$3.8m of cash over the last year. So suffice it to say we consider the stock very risky. 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. For instance, we've identified 3 warning signs for Lucapa Diamond (1 doesn't sit too well with us) 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.

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.

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