Is Petra Diamonds (LON:PDL) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Petra Diamonds Limited (LON:PDL) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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.

Our analysis indicates that PDL is potentially undervalued!

What Is Petra Diamonds's Net Debt?

The image below, which you can click on for greater detail, shows that Petra Diamonds had debt of US$366.2m at the end of June 2022, a reduction from US$430.3m over a year. However, because it has a cash reserve of US$288.2m, its net debt is less, at about US$78.0m.

A Look At Petra Diamonds' Liabilities

The latest balance sheet data shows that Petra Diamonds had liabilities of US$90.3m due within a year, and liabilities of US$542.1m falling due after that. Offsetting this, it had US$288.2m in cash and US$49.8m in receivables that were due within 12 months. So it has liabilities totalling US$294.4m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$247.4m, we think shareholders really should watch Petra Diamonds's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Petra Diamonds has a very low debt to EBITDA ratio of 0.30 so it is strange to see weak interest coverage, with last year's EBIT being only 1.9 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Notably, Petra Diamonds's EBIT launched higher than Elon Musk, gaining a whopping 806% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Petra 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.

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. Happily for any shareholders, Petra Diamonds actually produced more free cash flow than EBIT over the last two years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Both Petra Diamonds's ability to to convert EBIT to free cash flow and its EBIT growth rate gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to cover its interest expense with its EBIT. When we consider all the elements mentioned above, it seems to us that Petra Diamonds is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Be aware that Petra Diamonds is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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. 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.