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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. We can see that G8 Education Limited (ASX:GEM) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is G8 Education's Debt?
The image below, which you can click on for greater detail, shows that G8 Education had debt of AU$94.9m at the end of June 2021, a reduction from AU$293.9m over a year. However, its balance sheet shows it holds AU$106.5m in cash, so it actually has AU$11.6m net cash.
How Healthy Is G8 Education's Balance Sheet?
According to the last reported balance sheet, G8 Education had liabilities of AU$265.3m due within 12 months, and liabilities of AU$704.5m due beyond 12 months. On the other hand, it had cash of AU$106.5m and AU$18.6m worth of receivables due within a year. So it has liabilities totalling AU$844.6m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of AU$978.7m, so it does suggest shareholders should keep an eye on G8 Education's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, G8 Education boasts net cash, so it's fair to say it does not have a heavy debt load!
It is well worth noting that G8 Education's EBIT shot up like bamboo after rain, gaining 46% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine G8 Education'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. While G8 Education 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 three years, G8 Education generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Although G8 Education'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$11.6m. And it impressed us with free cash flow of AU$147m, being 89% of its EBIT. So we are not troubled with G8 Education's debt use. 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. To that end, you should be aware of the 1 warning sign we've spotted with G8 Education .
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.
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.
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