Is Lovisa Holdings (ASX:LOV) Using Too Much Debt?

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. We can see that Lovisa Holdings Limited (ASX:LOV) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Lovisa Holdings

What Is Lovisa Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 Lovisa Holdings had AU$43.0m of debt, an increase on AU$26.0m, over one year. However, it does have AU$58.5m in cash offsetting this, leading to net cash of AU$15.5m.

How Healthy Is Lovisa Holdings' Balance Sheet?

According to the last reported balance sheet, Lovisa Holdings had liabilities of AU$135.1m due within 12 months, and liabilities of AU$300.3m due beyond 12 months. Offsetting these obligations, it had cash of AU$58.5m as well as receivables valued at AU$20.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$356.3m.

Of course, Lovisa Holdings has a market capitalization of AU$3.40b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Lovisa Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

And we also note warmly that Lovisa Holdings grew its EBIT by 17% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Lovisa 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. Lovisa Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Lovisa Holdings generated free cash flow amounting to a very robust 98% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

Although Lovisa Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$15.5m. And it impressed us with free cash flow of AU$107m, being 98% of its EBIT. So we don't think Lovisa Holdings's use of debt is risky. 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, we've discovered 1 warning sign for Lovisa Holdings that you should be aware of before investing here.

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.

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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.