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. As with many other companies Gattaca plc (LON:GATC) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
What Is Gattaca's Debt?
You can click the graphic below for the historical numbers, but it shows that Gattaca had UK£7.46m of debt in July 2020, down from UK£44.0m, one year before. However, its balance sheet shows it holds UK£34.8m in cash, so it actually has UK£27.3m net cash.
How Healthy Is Gattaca's Balance Sheet?
According to the last reported balance sheet, Gattaca had liabilities of UK£49.8m due within 12 months, and liabilities of UK£15.9m due beyond 12 months. On the other hand, it had cash of UK£34.8m and UK£48.9m worth of receivables due within a year. So it actually has UK£18.0m more liquid assets than total liabilities.
This luscious liquidity implies that Gattaca's balance sheet is sturdy like a giant sequoia tree. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Succinctly put, Gattaca boasts net cash, so it's fair to say it does not have a heavy debt load!
Importantly, Gattaca's EBIT fell a jaw-dropping 72% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Gattaca's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Gattaca 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. Happily for any shareholders, Gattaca actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While we empathize with investors who find debt concerning, you should keep in mind that Gattaca has net cash of UK£27.3m, as well as more liquid assets than liabilities. The cherry on top was that in converted 323% of that EBIT to free cash flow, bringing in UK£55m. So we don't think Gattaca's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Gattaca you should be aware of, and 1 of them doesn't sit too well with us.
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.
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. 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.
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