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.' 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. We can see that Lifestyle Communities Limited (ASX:LIC) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.
View our latest analysis for Lifestyle Communities
What Is Lifestyle Communities's Net Debt?
As you can see below, at the end of June 2022, Lifestyle Communities had AU$245.0m of debt, up from AU$190.0m a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.
A Look At Lifestyle Communities' Liabilities
Zooming in on the latest balance sheet data, we can see that Lifestyle Communities had liabilities of AU$107.4m due within 12 months and liabilities of AU$445.4m due beyond that. On the other hand, it had cash of AU$1.89m and AU$963.0k worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$549.9m.
While this might seem like a lot, it is not so bad since Lifestyle Communities has a market capitalization of AU$1.73b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Strangely Lifestyle Communities has a sky high EBITDA ratio of 6.3, implying high debt, but a strong interest coverage of 23.6. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, Lifestyle Communities grew its EBIT by 58% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Lifestyle Communities'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Lifestyle Communities reported free cash flow worth 5.1% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Our View
Lifestyle Communities's net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Lifestyle Communities'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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Lifestyle Communities (of which 1 is concerning!) you should know about.
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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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.
About ASX:LIC
Lifestyle Communities
Provides housing for its homeowners in community in Australia.
Reasonable growth potential with mediocre balance sheet.