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. 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. As with many other companies Lonza Group Ltd (VTX:LONN) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Lonza Group Carry?
You can click the graphic below for the historical numbers, but it shows that Lonza Group had CHF3.77b of debt in June 2019, down from CHF4.22b, one year before. However, it does have CHF413.0m in cash offsetting this, leading to net debt of about CHF3.36b.
How Healthy Is Lonza Group’s Balance Sheet?
We can see from the most recent balance sheet that Lonza Group had liabilities of CHF2.25b falling due within a year, and liabilities of CHF4.99b due beyond that. Offsetting these obligations, it had cash of CHF413.0m as well as receivables valued at CHF775.0m due within 12 months. So its liabilities total CHF6.06b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Lonza Group is worth a massive CHF25.0b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Lonza Group’s net debt of 2.2 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.1 times interest expense) certainly does not do anything to dispel this impression. Lonza Group grew its EBIT by 8.4% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Lonza Group can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Lonza Group recorded free cash flow of 32% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Lonza Group’s interest cover was a real positive on this analysis, as was its EBIT growth rate. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Lonza Group’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you’re interested in Lonza Group, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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