Lendlease Group (ASX:LLC) Use Of Debt Could Be Considered Risky

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Lendlease Group (ASX:LLC) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Lendlease Group

What Is Lendlease Group's Net Debt?

As you can see below, at the end of December 2022, Lendlease Group had AU$3.20b of debt, up from AU$2.54b a year ago. Click the image for more detail. However, it does have AU$579.0m in cash offsetting this, leading to net debt of about AU$2.62b.

How Strong Is Lendlease Group's Balance Sheet?

According to the last reported balance sheet, Lendlease Group had liabilities of AU$4.97b due within 12 months, and liabilities of AU$5.66b due beyond 12 months. Offsetting these obligations, it had cash of AU$579.0m as well as receivables valued at AU$1.69b due within 12 months. So it has liabilities totalling AU$8.36b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the AU$4.97b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Lendlease Group would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Weak interest cover of 0.032 times and a disturbingly high net debt to EBITDA ratio of 24.1 hit our confidence in Lendlease Group like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for Lendlease Group is that it turned last year's EBIT loss into a gain of AU$3.0m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Lendlease 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Lendlease Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Lendlease 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. Having said that, its ability to grow its EBIT isn't such a worry. Considering all the factors previously mentioned, we think that Lendlease Group really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. For example - Lendlease Group has 1 warning sign we think you should be aware of.

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. 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.