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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.’ 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. As with many other companies. Leon’s Furniture Limited (TSE:LNF) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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.
What Is Leon’s Furniture’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Leon’s Furniture had CA$188.3m of debt in March 2019, down from CA$248.1m, one year before However, because it has a cash reserve of CA$101.3m, its net debt is less, at about CA$87.0m.
How Healthy Is Leon’s Furniture’s Balance Sheet?
The latest balance sheet data shows that Leon’s Furniture had liabilities of CA$598.2m due within a year, and liabilities of CA$583.9m falling due after that. Offsetting these obligations, it had cash of CA$101.3m as well as receivables valued at CA$120.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$960.2m.
This is a mountain of leverage relative to its market capitalization of CA$1.17b. So should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Since Leon’s Furniture does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Leon’s Furniture’s net debt is only 0.42 times its EBITDA. And its EBIT covers its interest expense a whopping 13.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Leon’s Furniture grew its EBIT by 3.3% in the last year, making that debt load look even more manageable. There’s no doubt that we learn most about debt from the balance sheet. 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’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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Leon’s Furniture generated free cash flow amounting to a very robust 88% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Happily, Leon’s Furniture’s impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Leon’s Furniture can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. We’d be motivated to research the stock further if we found out that Leon’s Furniture insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions 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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.