We Think Locality Planning Energy Holdings (ASX:LPE) Is Taking Some Risk With Its Debt

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. As with many other companies Locality Planning Energy Holdings Limited (ASX:LPE) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

Check out our latest analysis for Locality Planning Energy Holdings

What Is Locality Planning Energy Holdings's Debt?

As you can see below, at the end of June 2021, Locality Planning Energy Holdings had AU$14.1m of debt, up from AU$13.6m a year ago. Click the image for more detail. However, because it has a cash reserve of AU$6.36m, its net debt is less, at about AU$7.77m.

A Look At Locality Planning Energy Holdings' Liabilities

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. Offsetting this, it had AU$6.36m in cash and AU$11.2m in receivables that were due within 12 months. So its liabilities total AU$10.3m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of AU$14.9m, so it does suggest shareholders should keep an eye on Locality Planning Energy Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Locality Planning Energy Holdings's debt is 2.7 times its EBITDA, and its EBIT cover its interest expense 2.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One redeeming factor for Locality Planning Energy Holdings is that it turned last year's EBIT loss into a gain of AU$2.5m, over the last twelve months. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Locality Planning Energy Holdings 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

We'd go so far as to say Locality Planning Energy Holdings's conversion of EBIT to free cash flow was disappointing. Having said that, its ability to grow its EBIT isn't such a worry. It's also worth noting that Locality Planning Energy Holdings is in the Electric Utilities industry, which is often considered to be quite defensive. Overall, we think it's fair to say that Locality Planning Energy Holdings has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 5 warning signs with Locality Planning Energy Holdings (at least 3 which can't be ignored) , and understanding them should be part of your investment process.

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.