Is Gem Diamonds (LON:GEMD) Using Too Much Debt?

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. Importantly, Gem Diamonds Limited (LON:GEMD) does carry debt. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out 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$21.0m at the end of December 2024, a reduction from US$38.6m over a year. However, it does have US$12.9m in cash offsetting this, leading to net debt of about US$8.12m.

A Look At Gem Diamonds' Liabilities

Zooming in on the latest balance sheet data, we can see that Gem Diamonds had liabilities of US$25.4m due within 12 months and liabilities of US$100.8m due beyond that. Offsetting these obligations, it had cash of US$12.9m as well as receivables valued at US$5.14m due within 12 months. So its liabilities total US$108.2m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$16.4m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Gem Diamonds would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Gem Diamonds's low debt to EBITDA ratio of 0.33 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.9 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Notably, Gem Diamonds's EBIT launched higher than Elon Musk, gaining a whopping 198% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Gem Diamonds 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Gem Diamonds created free cash flow amounting to 8.0% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

We'd go so far as to say Gem Diamonds's level of total liabilities was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Gem Diamonds's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. For example Gem Diamonds has 2 warning signs (and 1 which can't be ignored) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.