AJ Lucas Group (ASX:AJL) Seems To Be Using A Lot Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 AJ Lucas Group Limited (ASX:AJL) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for AJ Lucas Group

How Much Debt Does AJ Lucas Group Carry?

The image below, which you can click on for greater detail, shows that AJ Lucas Group had debt of AU$102.6m at the end of June 2021, a reduction from AU$108.7m over a year. However, it does have AU$5.14m in cash offsetting this, leading to net debt of about AU$97.5m.

A Look At AJ Lucas Group's Liabilities

According to the last reported balance sheet, AJ Lucas Group had liabilities of AU$59.2m due within 12 months, and liabilities of AU$78.3m due beyond 12 months. Offsetting these obligations, it had cash of AU$5.14m as well as receivables valued at AU$18.7m due within 12 months. So it has liabilities totalling AU$113.7m more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the AU$38.3m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, AJ Lucas Group would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

AJ Lucas Group shareholders face the double whammy of a high net debt to EBITDA ratio (5.1), and fairly weak interest coverage, since EBIT is just 0.95 times the interest expense. The debt burden here is substantial. Fortunately, AJ Lucas Group grew its EBIT by 9.4% in the last year, slowly shrinking its debt relative to earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But it is AJ Lucas Group's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, AJ Lucas Group reported free cash flow worth 3.6% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both AJ Lucas Group's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. After considering the datapoints discussed, we think AJ Lucas Group has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with AJ Lucas Group (including 1 which is potentially serious) .

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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