Gamma Communications (LON:GAMA) Seems To Use Debt Rather Sparingly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that Gamma Communications plc (LON:GAMA) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Gamma Communications

What Is Gamma Communications's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Gamma Communications had debt of UK£5.90m, up from none in one year. But on the other hand it also has UK£53.9m in cash, leading to a UK£48.0m net cash position.

How Healthy Is Gamma Communications' Balance Sheet?

We can see from the most recent balance sheet that Gamma Communications had liabilities of UK£74.6m falling due within a year, and liabilities of UK£42.9m due beyond that. Offsetting this, it had UK£53.9m in cash and UK£96.3m in receivables that were due within 12 months. So it actually has UK£32.7m more liquid assets than total liabilities.

Having regard to Gamma Communications' size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the UK£1.84b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Gamma Communications has more cash than debt is arguably a good indication that it can manage its debt safely.

Another good sign is that Gamma Communications has been able to increase its EBIT by 21% in twelve months, making it easier to pay down 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 Gamma Communications 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Gamma Communications 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. During the last three years, Gamma Communications produced sturdy free cash flow equating to 72% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Gamma Communications has net cash of UK£48.0m, as well as more liquid assets than liabilities. The cherry on top was that in converted 72% of that EBIT to free cash flow, bringing in UK£41m. So we don't think Gamma Communications's use of debt is risky. 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. Be aware that Gamma Communications is showing 2 warning signs in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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