Lotus Bakeries (EBR:LOTB) Seems To Use Debt Quite Sensibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Lotus Bakeries NV (EBR:LOTB) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Lotus Bakeries

What Is Lotus Bakeries's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Lotus Bakeries had debt of €260.8m, up from €231.3m in one year. On the flip side, it has €91.1m in cash leading to net debt of about €169.8m.

How Healthy Is Lotus Bakeries' Balance Sheet?

The latest balance sheet data shows that Lotus Bakeries had liabilities of €219.1m due within a year, and liabilities of €286.8m falling due after that. Offsetting these obligations, it had cash of €91.1m as well as receivables valued at €123.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €291.7m.

Of course, Lotus Bakeries has a market capitalization of €4.99b, 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Lotus Bakeries has a low net debt to EBITDA ratio of only 1.1. And its EBIT easily covers its interest expense, being 46.4 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Lotus Bakeries has increased its EBIT by 6.4% over twelve months, which should ease any concerns about debt repayment. 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 Lotus Bakeries'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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Lotus Bakeries recorded free cash flow of 48% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Lotus Bakeries's impressive interest cover implies it has the upper hand on its debt. And we also thought its net debt to EBITDA was a positive. When we consider the range of factors above, it looks like Lotus Bakeries is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Lotus Bakeries's earnings per share history for free.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.