We Think Lynch Group Holdings (ASX:LGL) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Lynch Group Holdings Limited (ASX:LGL) makes use of debt. But the real question is whether this debt is making the company risky.

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When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.

What Is Lynch Group Holdings's Debt?

The chart below, which you can click on for greater detail, shows that Lynch Group Holdings had AU$55.0m in debt in December 2024; about the same as the year before. However, it does have AU$17.1m in cash offsetting this, leading to net debt of about AU$38.0m.

How Strong Is Lynch Group Holdings' Balance Sheet?

We can see from the most recent balance sheet that Lynch Group Holdings had liabilities of AU$69.0m falling due within a year, and liabilities of AU$95.0m due beyond that. Offsetting these obligations, it had cash of AU$17.1m as well as receivables valued at AU$29.7m due within 12 months. So its liabilities total AU$117.3m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of AU$183.1m, so it does suggest shareholders should keep an eye on Lynch Group Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

See our latest analysis for Lynch Group Holdings

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Lynch Group Holdings has a very low debt to EBITDA ratio of 1.2 so it is strange to see weak interest coverage, with last year's EBIT being only 1.8 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Shareholders should be aware that Lynch Group Holdings's EBIT was down 44% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Lynch Group Holdings'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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Lynch Group Holdings produced sturdy free cash flow equating to 75% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both Lynch Group Holdings's EBIT growth rate and its interest cover were discouraging. But at least its conversion of EBIT to free cash flow is a gleaming silver lining to those clouds. When we consider all the factors discussed, it seems to us that Lynch Group Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Lynch Group Holdings that you should be aware of before investing here.

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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.