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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. 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 Gear4music (Holdings) plc (LON:G4M) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.
How Much Debt Does Gear4music (Holdings) Carry?
As you can see below, at the end of March 2019, Gear4music (Holdings) had UK£12.4m of debt, up from UK£8.53m a year ago. Click the image for more detail. However, it does have UK£5.30m in cash offsetting this, leading to net debt of about UK£7.07m.
A Look At Gear4music (Holdings)'s Liabilities
Zooming in on the latest balance sheet data, we can see that Gear4music (Holdings) had liabilities of UK£20.1m due within 12 months and liabilities of UK£5.42m due beyond that. On the other hand, it had cash of UK£5.30m and UK£856.0k worth of receivables due within a year. So its liabilities total UK£19.3m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Gear4music (Holdings) is worth UK£41.9m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 0.065 times and a disturbingly high net debt to EBITDA ratio of 6.8 hit our confidence in Gear4music (Holdings) like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Gear4music (Holdings) saw its EBIT tank 99% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Gear4music (Holdings) burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Gear4music (Holdings)'s conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to handle its total liabilities isn't such a worry. After considering the datapoints discussed, we think Gear4music (Holdings) has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given the risks around Gear4music (Holdings)'s use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.