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.’ 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. We can see that The Gym Group plc (LON:GYM) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, 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.
What Is Gym Group’s Net Debt?
As you can see below, Gym Group had UK£35.3m of debt at June 2020, down from UK£50.4m a year prior. However, because it has a cash reserve of UK£6.84m, its net debt is less, at about UK£28.4m.
A Look At Gym Group’s Liabilities
We can see from the most recent balance sheet that Gym Group had liabilities of UK£42.6m falling due within a year, and liabilities of UK£313.9m due beyond that. On the other hand, it had cash of UK£6.84m and UK£4.61m worth of receivables due within a year. So its liabilities total UK£345.1m more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the UK£225.8m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Gym Group would likely require a major re-capitalisation if it had to pay its creditors today. 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 Gym Group 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.
In the last year Gym Group had a loss before interest and tax, and actually shrunk its revenue by 17%, to UK£116m. That’s not what we would hope to see.
Not only did Gym Group’s revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). To be specific the EBIT loss came in at UK£4.5m. When we look at that alongside the significant liabilities, we’re not particularly confident about the company. We’d want to see some strong near-term improvements before getting too interested in the stock. Not least because it burned through UK£488k in negative free cash flow over the last year. That means it’s on the risky side of things. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. Consider for instance, the ever-present spectre of investment risk. We’ve identified 2 warning signs with Gym Group , and understanding them should be part of your investment process.
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.
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