Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Gamma Communications plc (LON:GAMA) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Gamma Communications Carry?
The image below, which you can click on for greater detail, shows that at June 2021 Gamma Communications had debt of UK£5.20m, up from UK£3.80m in one year. However, its balance sheet shows it holds UK£30.8m in cash, so it actually has UK£25.6m net cash.
How Strong Is Gamma Communications' Balance Sheet?
The latest balance sheet data shows that Gamma Communications had liabilities of UK£78.7m due within a year, and liabilities of UK£38.9m falling due after that. Offsetting this, it had UK£30.8m in cash and UK£102.4m in receivables that were due within 12 months. So it actually has UK£15.6m more liquid assets than total liabilities.
This state of affairs indicates that Gamma Communications' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the UK£2.02b company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, Gamma Communications boasts net cash, so it's fair to say it does not have a heavy debt load!
Also positive, Gamma Communications grew its EBIT by 23% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Gamma Communications 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Gamma Communications 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. During the last three years, Gamma Communications produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
While we empathize with investors who find debt concerning, you should keep in mind that Gamma Communications has net cash of UK£25.6m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of UK£52m, being 76% of its EBIT. So is Gamma Communications's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - Gamma Communications has 1 warning sign we think you should be aware of.
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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