Does Gemfields Group (JSE:GML) Have A Healthy Balance Sheet?

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.' 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 note that Gemfields Group Limited (JSE:GML) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Our analysis indicates that GML is potentially undervalued!

What Is Gemfields Group's Debt?

As you can see below, Gemfields Group had US$29.7m of debt at June 2022, down from US$38.6m a year prior. However, it does have US$111.5m in cash offsetting this, leading to net cash of US$81.8m.

How Healthy Is Gemfields Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Gemfields Group had liabilities of US$89.9m due within 12 months and liabilities of US$116.2m due beyond that. On the other hand, it had cash of US$111.5m and US$110.7m worth of receivables due within a year. So it actually has US$16.1m more liquid assets than total liabilities.

This surplus suggests that Gemfields Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Gemfields Group has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Gemfields Group grew its EBIT by 873% over twelve months. That boost will make it even 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 Gemfields Group 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Gemfields Group 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, Gemfields Group produced sturdy free cash flow equating to 54% 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 Gemfields Group has net cash of US$81.8m, as well as more liquid assets than liabilities. And we liked the look of last year's 873% year-on-year EBIT growth. So is Gemfields Group'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. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Gemfields Group that 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.