Stock Analysis

Does Linamar (TSE:LNR) Have A Healthy Balance Sheet?

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TSX:LNR
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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Linamar Corporation (TSE:LNR) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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.

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How Much Debt Does Linamar Carry?

The image below, which you can click on for greater detail, shows that Linamar had debt of CA$1.24b at the end of December 2020, a reduction from CA$1.85b over a year. However, it also had CA$861.1m in cash, and so its net debt is CA$376.3m.

debt-equity-history-analysis
TSX:LNR Debt to Equity History May 3rd 2021

How Healthy Is Linamar's Balance Sheet?

The latest balance sheet data shows that Linamar had liabilities of CA$2.20b due within a year, and liabilities of CA$1.01b falling due after that. Offsetting these obligations, it had cash of CA$861.1m as well as receivables valued at CA$963.3m due within 12 months. So it has liabilities totalling CA$1.38b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Linamar has a market capitalization of CA$4.71b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Linamar has a low net debt to EBITDA ratio of only 0.43. And its EBIT covers its interest expense a whopping 30.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Linamar's load is not too heavy, because its EBIT was down 31% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Linamar'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 that EBIT is backed by free cash flow. Over the last three years, Linamar recorded free cash flow worth a fulsome 99% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Linamar's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the elements mentioned above, it seems to us that Linamar is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Linamar has 2 warning signs (and 1 which is concerning) we think you should know about.

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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