Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Locality Planning Energy Holdings Limited (ASX:LPE) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Locality Planning Energy Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2021 Locality Planning Energy Holdings had debt of AU$14.3m, up from AU$13.6m in one year. However, because it has a cash reserve of AU$5.75m, its net debt is less, at about AU$8.52m.
How Strong Is Locality Planning Energy Holdings' Balance Sheet?
The latest balance sheet data shows that Locality Planning Energy Holdings had liabilities of AU$12.6m due within a year, and liabilities of AU$15.2m falling due after that. On the other hand, it had cash of AU$5.75m and AU$11.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$10.9m.
This is a mountain of leverage relative to its market capitalization of AU$13.8m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Locality Planning Energy Holdings has a quite reasonable net debt to EBITDA multiple of 2.3, its interest cover seems weak, at 1.4. This does have us wondering if the company pays high interest because it is considered risky. Either way there's no doubt the stock is using meaningful leverage. We also note that Locality Planning Energy Holdings improved its EBIT from a last year's loss to a positive AU$3.0m. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Locality Planning Energy Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Locality Planning Energy Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Locality Planning Energy Holdings's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. We should also note that Electric Utilities industry companies like Locality Planning Energy Holdings commonly do use debt without problems. We're quite clear that we consider Locality Planning Energy Holdings to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Locality Planning Energy Holdings has 6 warning signs (and 3 which make us uncomfortable) we think you should know about.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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Locality Planning Energy Holdings
Locality Planning Energy Holdings Limited provides electricity and utility services to residential and commercial customers throughout the Australian National Electricity Market.
Solid track record with mediocre balance sheet.