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Lucara Diamond (TSE:LUC) Takes On Some Risk With Its Use Of Debt

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.' 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 Lucara Diamond Corp. (TSE:LUC) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

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Check out our latest analysis for Lucara Diamond

How Much Debt Does Lucara Diamond Carry?

As you can see below, at the end of March 2020, Lucara Diamond had US$19.0m of debt, up from none a year ago. Click the image for more detail. However, it does have US$27.4m in cash offsetting this, leading to net cash of US$8.38m.

debt-equity-history-analysis
debt-equity-history-analysis

A Look At Lucara Diamond's Liabilities

According to the last reported balance sheet, Lucara Diamond had liabilities of US$38.5m due within 12 months, and liabilities of US$77.3m due beyond 12 months. Offsetting this, it had US$27.4m in cash and US$8.17m in receivables that were due within 12 months. So it has liabilities totalling US$80.2m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Lucara Diamond is worth US$166.2m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Lucara Diamond boasts net cash, so it's fair to say it does not have a heavy debt load!

Shareholders should be aware that Lucara Diamond's EBIT was down 82% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Lucara Diamond'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. While Lucara Diamond 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. In the last three years, Lucara Diamond's free cash flow amounted to 30% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing up

Although Lucara Diamond's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$8.38m. Despite its cash we think that Lucara Diamond seems to struggle to grow its EBIT, so we are wary of the stock. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Lucara Diamond that you should be aware of before investing here.

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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.