Leon's Furniture (TSE:LNF) Takes On Some Risk With Its Use Of Debt

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.' 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. We can see that Leon's Furniture Limited (TSE:LNF) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for Leon's Furniture

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$160.0m of debt in September 2023, down from CA$236.3m, one year before. However, it does have CA$212.1m in cash offsetting this, leading to net cash of CA$52.1m.

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$621.5m falling due within a year, and liabilities of CA$620.0m due beyond that. Offsetting these obligations, it had cash of CA$212.1m as well as receivables valued at CA$188.6m due within 12 months. So it has liabilities totalling CA$840.7m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CA$1.32b, so it does suggest shareholders should keep an eye on Leon's Furniture's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. 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.

It is just as well that Leon's Furniture's load is not too heavy, because its EBIT was down 32% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Leon's Furniture 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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 most recent three years, Leon's Furniture recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

Although Leon's Furniture'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$52.1m. The cherry on top was that in converted 69% of that EBIT to free cash flow, bringing in CA$219m. So while Leon's Furniture does not have a great balance sheet, it's certainly not too bad. 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. For example - Leon's Furniture has 1 warning sign we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.