Is Leon's Furniture (TSE:LNF) A Risky Investment?

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 Leon's Furniture Limited (TSE:LNF) makes use of debt. But the real question is whether this debt is making the company risky.

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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Leon's Furniture

What Is Leon's Furniture's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Leon's Furniture had debt of CA$240.0m, up from CA$90.0m in one year. However, its balance sheet shows it holds CA$246.9m in cash, so it actually has CA$6.84m net cash.

How Healthy Is Leon's Furniture's Balance Sheet?

We can see from the most recent balance sheet that Leon's Furniture had liabilities of CA$831.4m falling due within a year, and liabilities of CA$683.4m due beyond that. On the other hand, it had cash of CA$246.9m and CA$178.5m worth of receivables due within a year. So it has liabilities totalling CA$1.09b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of CA$1.09b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Leon's Furniture also has more cash than debt, so we're pretty confident it can manage its debt safely.

And we also note warmly that Leon's Furniture grew its EBIT by 12% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Leon's Furniture'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 company can only pay off debt with cold hard cash, not accounting profits. Leon's Furniture 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, Leon's Furniture actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

While Leon's Furniture does have more liabilities than liquid assets, it also has net cash of CA$6.84m. The cherry on top was that in converted 132% of that EBIT to free cash flow, bringing in CA$220m. So we don't have any problem with Leon's Furniture's use of debt. 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 2 warning signs with Leon's Furniture , and understanding them should be part of your investment process.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.