These 4 Measures Indicate That AJ Lucas Group (ASX:AJL) Is Using Debt Extensively

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, AJ Lucas Group Limited (ASX:AJL) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for AJ Lucas Group

What Is AJ Lucas Group's Debt?

The chart below, which you can click on for greater detail, shows that AJ Lucas Group had AU$101.1m in debt in December 2020; about the same as the year before. However, because it has a cash reserve of AU$12.5m, its net debt is less, at about AU$88.6m.

A Look At AJ Lucas Group's Liabilities

Zooming in on the latest balance sheet data, we can see that AJ Lucas Group had liabilities of AU$56.3m due within 12 months and liabilities of AU$80.4m due beyond that. Offsetting these obligations, it had cash of AU$12.5m as well as receivables valued at AU$18.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$106.0m.

This deficit casts a shadow over the AU$32.3m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, AJ Lucas Group would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While AJ Lucas Group's debt to EBITDA ratio (3.5) suggests that it uses some debt, its interest cover is very weak, at 1.3, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The good news is that AJ Lucas Group grew its EBIT a smooth 36% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is AJ Lucas Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, AJ Lucas Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, AJ Lucas Group's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that AJ Lucas Group's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. To that end, you should learn about the 4 warning signs we've spotted with AJ Lucas Group (including 1 which is a bit unpleasant) .

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.

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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.
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