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 Lonza Group Ltd (VTX:LONN) does use debt in its business. But is this debt a concern to shareholders?
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. 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. 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 examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Lonza Group Carry?
The image below, which you can click on for greater detail, shows that Lonza Group had debt of CHF3.65b at the end of December 2019, a reduction from CHF4.11b over a year. However, it also had CHF505.0m in cash, and so its net debt is CHF3.14b.
How Healthy Is Lonza Group’s Balance Sheet?
According to the last reported balance sheet, Lonza Group had liabilities of CHF2.68b due within 12 months, and liabilities of CHF4.60b due beyond 12 months. Offsetting these obligations, it had cash of CHF505.0m as well as receivables valued at CHF846.0m due within 12 months. So its liabilities total CHF5.93b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Lonza Group has a huge market capitalization of CHF28.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Lonza Group’s net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its strong interest cover of 16.2 times, makes us even more comfortable. Lonza Group grew its EBIT by 7.2% in the last year. That’s far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Lonza Group’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. In the last three years, Lonza Group’s free cash flow amounted to 37% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
On our analysis Lonza Group’s interest cover should signal that it won’t have too much trouble with its debt. However, our other observations weren’t so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Considering this range of data points, we think Lonza Group is in a good position to manage its debt levels. 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, we’ve discovered 1 warning sign for Lonza Group that you should be aware of before investing here.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.
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