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.' 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. We note that GEM Co., Ltd. (SZSE:002340) 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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does GEM Carry?
The image below, which you can click on for greater detail, shows that at September 2023 GEM had debt of CN¥18.2b, up from CN¥14.8b in one year. However, because it has a cash reserve of CN¥3.53b, its net debt is less, at about CN¥14.7b.
A Look At GEM's Liabilities
We can see from the most recent balance sheet that GEM had liabilities of CN¥17.0b falling due within a year, and liabilities of CN¥8.92b due beyond that. Offsetting this, it had CN¥3.53b in cash and CN¥6.42b in receivables that were due within 12 months. So its liabilities total CN¥16.0b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of CN¥26.4b, so it does suggest shareholders should keep an eye on GEM's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 2.5 times and a disturbingly high net debt to EBITDA ratio of 5.4 hit our confidence in GEM like a one-two punch to the gut. The debt burden here is substantial. Investors should also be troubled by the fact that GEM saw its EBIT drop by 14% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine GEM's ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, GEM saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
On the face of it, GEM's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its interest cover also fails to instill confidence. Overall, it seems to us that GEM's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for GEM (of which 1 is significant!) you should know about.
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.
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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.