Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Geodrill Limited (TSE:GEO) makes use of debt. But the more important question is: how much risk is that debt creating?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
How Much Debt Does Geodrill Carry?
As you can see below, Geodrill had US$2.62m of debt at June 2020, down from US$5.77m a year prior. But it also has US$8.09m in cash to offset that, meaning it has US$5.47m net cash.
A Look At Geodrill's Liabilities
Zooming in on the latest balance sheet data, we can see that Geodrill had liabilities of US$14.2m due within 12 months and liabilities of US$3.31m due beyond that. Offsetting this, it had US$8.09m in cash and US$19.3m in receivables that were due within 12 months. So it can boast US$9.89m more liquid assets than total liabilities.
This surplus suggests that Geodrill is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, Geodrill boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, Geodrill's EBIT dived 19%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Geodrill 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Geodrill has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Geodrill reported free cash flow worth 4.2% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
While we empathize with investors who find debt concerning, you should keep in mind that Geodrill has net cash of US$5.47m, as well as more liquid assets than liabilities. So we are not troubled with Geodrill's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Geodrill .
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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