While small-cap stocks, such as Leon’s Furniture Limited (TSX:LNF) with its market cap of USD $915 Million, are popular for their explosive growth, investors should also pay heed to their balance sheet to judge whether the company can survive a downturn. Why is it important? A major downturn in the energy industry has resulted in over 150 companies going bankrupt and has put more than 100 on the verge of a collapse, primarily due to excessive debt.
When a company is faced with an extreme event undercutting its profits or disrupting its operations temporarily, it’s the company’s ability to meet short-term obligations which allows it to remain in the business. Here are few basic financial health checks to judge whether a company fits the bill or there is an additional risk which you should consider before taking the plunge. View our latest analysis for Leon’s Furniture
Does LNF generate enough cash through operations to meet all its needs?
While in short-term operating cash flows can be volatile, on an annual basis, they reflect the true picture of a company’s earnings quality and its ability to meet obligations. In the case of Leon’s Furniture, operating cash flow turned out to be 47.8% of its overall debt over the past twelve months. That means Leon’s Furniture’s core operations are generating enough cash to comfortably service its debt.
Can LNF pay its short-term debts?
While failure to manage cash has been one of the major reasons behind the demise of a lot of small businesses, the mismanagement comes into the limelight during tough situations such as economic recession, war, natural disaster, sudden increase in the price of raw materials, and a supply chain risk, which can put a company in a difficult situation. But that does not absolve the company from its obligations such as lease payments, interest payments, and salaries. In addition, failure to service debt and bank loans can seriously hurts its reputation, making funding extremely expensive in the future, if at all it survives. Leon’s Furniture is able to meet its short term (1 year) commitments with its holdings of cash and other short term assets.
Is Leon’s Furniture’s level of debt at an acceptable level?
Debt to equity ratio tells you if the company faces tough times or goes out of business, how much assets the debtors could claim. In the case of Leon’s Furniture, the debt-to-equity ratio is 52.4% and that means while Leon’s Furniture’s debt could pose a problem for its earnings stability, it’s not at an alarmingly high level yet. No matter how high is the debt, if a company can easily cover the interest payments, it’s considered to be making a good use of that excessive leverage. To keep an eye on how it’s doing on that front, an investor can check how easily the company can service its debt. If it earns at least 5x or more of its interest payments, that’s an indication of financial strength. In LNF’s case the interest on debt is not strongly covered (ideally 5x) by earnings (earnings are 4.8x annual interest expense).
While Leon’s Furniture falls short on the interest coverage, it does well in terms of generating a healthy amount of cash. But given its debt load, there are questions surrounding it’s overall financial strength, and at the present time it does not pass all basic checks in my list.
Now when you know whether you should keep the debt in mind as a risk factor when putting together your investment thesis, I recommend you check out our latest free analysis report on Leon’s Furniture to see what are LNF’s growth prospects and whether it could be considered an undervalued opportunity.
PS. If you are not interested in Leon’s Furniture anymore, you can use our free platform to see my list of over 150 other stocks with a high growth potential.