Stock Analysis

Gem Diamonds (LON:GEMD) Has A Somewhat Strained Balance Sheet

LSE:GEMD
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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Gem Diamonds Limited (LON:GEMD) does use debt in its business. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

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What Is Gem Diamonds's Debt?

As you can see below, Gem Diamonds had US$5.95m of debt at December 2022, down from US$11.0m a year prior. But it also has US$8.74m in cash to offset that, meaning it has US$2.80m net cash.

debt-equity-history-analysis
LSE:GEMD Debt to Equity History June 29th 2023

A Look At Gem Diamonds' Liabilities

The latest balance sheet data shows that Gem Diamonds had liabilities of US$23.2m due within a year, and liabilities of US$110.0m falling due after that. Offsetting this, it had US$8.74m in cash and US$5.81m in receivables that were due within 12 months. So its liabilities total US$118.6m more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$34.8m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Gem Diamonds would probably need a major re-capitalization if its creditors were to demand repayment. Gem Diamonds boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

The modesty of its debt load may become crucial for Gem Diamonds if management cannot prevent a repeat of the 28% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 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.

Finally, while the tax-man may adore accounting profits, lenders only accept 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 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

Although Gem Diamonds's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$2.80m. Despite the cash, we do find Gem Diamonds's level of total liabilities concerning, so we're not particularly comfortable with the stock. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Gem Diamonds (of which 1 shouldn't be ignored!) you should know about.

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.

Valuation is complex, but we're helping make it simple.

Find out whether Gem Diamonds is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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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.