Is Gear4music (Holdings) (LON:G4M) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Gear4music (Holdings) plc (LON:G4M) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Gear4music (Holdings)

What Is Gear4music (Holdings)'s Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2021 Gear4music (Holdings) had UK£17.0m of debt, an increase on UK£10.7m, over one year. However, it does have UK£3.65m in cash offsetting this, leading to net debt of about UK£13.4m.

How Strong Is Gear4music (Holdings)'s Balance Sheet?

We can see from the most recent balance sheet that Gear4music (Holdings) had liabilities of UK£16.7m falling due within a year, and liabilities of UK£28.5m due beyond that. Offsetting these obligations, it had cash of UK£3.65m as well as receivables valued at UK£1.10m due within 12 months. So it has liabilities totalling UK£40.5m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Gear4music (Holdings) is worth UK£115.4m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Gear4music (Holdings) has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 16.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that Gear4music (Holdings) grew its EBIT at 11% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Gear4music (Holdings) 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Gear4music (Holdings) reported free cash flow worth 15% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On our analysis Gear4music (Holdings)'s interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Gear4music (Holdings) is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example Gear4music (Holdings) has 3 warning signs (and 1 which is a bit concerning) we think you should know about.

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.