Gem Diamonds (LON:GEMD) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Gem Diamonds Limited (LON:GEMD) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Gem Diamonds

What Is Gem Diamonds's Net Debt?

The image below, which you can click on for greater detail, shows that Gem Diamonds had debt of US$11.0m at the end of December 2021, a reduction from US$16.1m over a year. However, its balance sheet shows it holds US$30.9m in cash, so it actually has US$19.9m net cash.

How Strong Is Gem Diamonds' Balance Sheet?

According to the last reported balance sheet, Gem Diamonds had liabilities of US$30.0m due within 12 months, and liabilities of US$108.0m due beyond 12 months. Offsetting this, it had US$30.9m in cash and US$4.33m in receivables that were due within 12 months. So it has liabilities totalling US$102.7m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$119.9m, 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. While it does have liabilities worth noting, Gem Diamonds also has more cash than debt, so we're pretty confident it can manage its debt safely.

The good news is that Gem Diamonds has increased its EBIT by 3.0% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Gem Diamonds's ability to maintain a healthy balance sheet going forward. 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 Gem Diamonds 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. In the last three years, Gem Diamonds created free cash flow amounting to 19% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay 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$19.9m. On top of that, it increased its EBIT by 3.0% in the last twelve months. So although we see some areas for improvement, we're not too worried about Gem Diamonds's balance sheet. 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. For example, we've discovered 2 warning signs for Gem Diamonds that you should be aware of before investing here.

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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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.