Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Linamar Corporation (TSE:LNR) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Linamar's Debt?
The image below, which you can click on for greater detail, shows that Linamar had debt of CA$740.4m at the end of September 2021, a reduction from CA$1.38b over a year. But on the other hand it also has CA$806.0m in cash, leading to a CA$65.6m net cash position.
How Strong Is Linamar's Balance Sheet?
The latest balance sheet data shows that Linamar had liabilities of CA$1.68b due within a year, and liabilities of CA$1.05b falling due after that. Offsetting this, it had CA$806.0m in cash and CA$1.02b in receivables that were due within 12 months. So it has liabilities totalling CA$906.0m more than its cash and near-term receivables, combined.
Linamar has a market capitalization of CA$4.50b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Linamar boasts net cash, so it's fair to say it does not have a heavy debt load!
In addition to that, we're happy to report that Linamar has boosted its EBIT by 93%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Linamar can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Linamar may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Linamar actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Although Linamar's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CA$65.6m. And it impressed us with free cash flow of CA$920m, being 134% of its EBIT. So is Linamar's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Linamar is showing 1 warning sign in our investment analysis , 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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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.