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David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Atlas Pearls Limited (ASX:ATP) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 Atlas Pearls's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Atlas Pearls had AU$2.62m of debt in December 2021, down from AU$6.92m, one year before. But on the other hand it also has AU$4.42m in cash, leading to a AU$1.80m net cash position.
How Strong Is Atlas Pearls' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Atlas Pearls had liabilities of AU$7.28m due within 12 months and liabilities of AU$375.1k due beyond that. On the other hand, it had cash of AU$4.42m and AU$1.09m worth of receivables due within a year. So it has liabilities totalling AU$2.14m more than its cash and near-term receivables, combined.
Of course, Atlas Pearls has a market capitalization of AU$20.8m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Atlas Pearls also has more cash than debt, so we're pretty confident it can manage its debt safely.
Although Atlas Pearls made a loss at the EBIT level, last year, it was also good to see that it generated AU$8.5m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Atlas Pearls will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Atlas Pearls 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 year, Atlas Pearls generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Although Atlas Pearls's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$1.80m. And it impressed us with free cash flow of AU$6.9m, being 81% of its EBIT. So we don't think Atlas Pearls's use of debt is risky. 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. We've identified 3 warning signs with Atlas Pearls (at least 1 which is potentially serious) , and understanding them should be part of your investment process.
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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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.