The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. As with many other companies Gamma Communications plc (LON:GAMA) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Gamma Communications

What Is Gamma Communications's Debt?

As you can see below, at the end of June 2021, Gamma Communications had UK£5.20m of debt, up from UK£3.80m a year ago. Click the image for more detail. But it also has UK£30.8m in cash to offset that, meaning it has UK£25.6m net cash.

How Strong Is Gamma Communications' Balance Sheet?

The latest balance sheet data shows that Gamma Communications had liabilities of UK£78.7m due within a year, and liabilities of UK£38.9m falling due after that. Offsetting this, it had UK£30.8m in cash and UK£102.4m in receivables that were due within 12 months. So it actually has UK£15.6m more liquid assets than total liabilities.

This state of affairs indicates that Gamma Communications' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the UK£1.79b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Gamma Communications has more cash than debt is arguably a good indication that it can manage its debt safely.

Another good sign is that Gamma Communications has been able to increase its EBIT by 23% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Gamma Communications 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Gamma Communications 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. Over the most recent three years, Gamma Communications recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Gamma Communications has net cash of UK£25.6m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of UK£52m, being 76% of its EBIT. So we don't think Gamma Communications's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Gamma Communications .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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