Geodrill (TSE:GEO) Takes On Some Risk With Its Use Of Debt
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.' 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. Importantly, Geodrill Limited (TSE:GEO) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Geodrill
What Is Geodrill's Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Geodrill had US$6.37m of debt, an increase on US$5.10m, over one year. However, it also had US$3.92m in cash, and so its net debt is US$2.44m.
How Strong Is Geodrill's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Geodrill had liabilities of US$20.0m due within 12 months and liabilities of US$4.43m due beyond that. On the other hand, it had cash of US$3.92m and US$20.3m worth of receivables due within a year. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
Having regard to Geodrill's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the US$51.8m company is short on cash, but still worth keeping an eye on the balance sheet.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Geodrill has a low net debt to EBITDA ratio of only 0.16. And its EBIT easily covers its interest expense, being 15.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Geodrill's load is not too heavy, because its EBIT was down 31% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Geodrill 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Geodrill actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
Our View
Geodrill's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We think that Geodrill's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.
