Does Gem Diamonds (LON:GEMD) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Gem Diamonds Limited (LON:GEMD) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Gem Diamonds

How Much Debt Does Gem Diamonds Carry?

You can click the graphic below for the historical numbers, but it shows that Gem Diamonds had US$16.1m of debt in December 2020, down from US$22.3m, one year before. But it also has US$49.8m in cash to offset that, meaning it has US$33.7m net cash.

How Strong Is Gem Diamonds' Balance Sheet?

The latest balance sheet data shows that Gem Diamonds had liabilities of US$61.2m due within a year, and liabilities of US$105.5m falling due after that. Offsetting these obligations, it had cash of US$49.8m as well as receivables valued at US$4.44m due within 12 months. So its liabilities total US$112.4m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of US$125.5m, so it does suggest shareholders should keep an eye on Gem Diamonds' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, Gem Diamonds boasts net cash, so it's fair to say it does not have a heavy debt load!

In addition to that, we're happy to report that Gem Diamonds has boosted its EBIT by 90%, thus reducing the spectre of future debt repayments. 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 Gem Diamonds 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Gem Diamonds 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 three years, Gem Diamonds's free cash flow amounted to 38% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing up

While Gem Diamonds does have more liabilities than liquid assets, it also has net cash of US$33.7m. And it impressed us with its EBIT growth of 90% over the last year. So we are not troubled with Gem Diamonds's debt use. 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. Be aware that Gem Diamonds is showing 3 warning signs in our investment analysis , and 1 of those is potentially serious...

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. 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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