Is LGI (ASX:LGI) A Risky Investment?

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.' 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. Importantly, LGI Limited (ASX:LGI) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for LGI

What Is LGI's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 LGI had AU$13.2m of debt, an increase on none, over one year. But it also has AU$16.6m in cash to offset that, meaning it has AU$3.41m net cash.

How Healthy Is LGI's Balance Sheet?

According to the last reported balance sheet, LGI had liabilities of AU$5.79m due within 12 months, and liabilities of AU$20.4m due beyond 12 months. Offsetting these obligations, it had cash of AU$16.6m as well as receivables valued at AU$2.06m due within 12 months. So it has liabilities totalling AU$7.56m more than its cash and near-term receivables, combined.

Since publicly traded LGI shares are worth a total of AU$251.0m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, LGI boasts net cash, so it's fair to say it does not have a heavy debt load!

On the other hand, LGI saw its EBIT drop by 9.0% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder 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 LGI'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. While LGI has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, LGI saw substantial negative free cash flow, in total. 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.

Summing Up

We could understand if investors are concerned about LGI's liabilities, but we can be reassured by the fact it has has net cash of AU$3.41m. So we don't have any problem with LGI's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that LGI is showing 2 warning signs in our investment analysis , and 1 of those is significant...

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.