Is LATAM Airlines Group (SNSE:LTM) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that LATAM Airlines Group S.A. (SNSE:LTM) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for LATAM Airlines Group

What Is LATAM Airlines Group's Debt?

The image below, which you can click on for greater detail, shows that LATAM Airlines Group had debt of US$3.08b at the end of March 2024, a reduction from US$4.57b over a year. However, because it has a cash reserve of US$1.85b, its net debt is less, at about US$1.22b.

How Strong Is LATAM Airlines Group's Balance Sheet?

The latest balance sheet data shows that LATAM Airlines Group had liabilities of US$5.69b due within a year, and liabilities of US$8.63b falling due after that. Offsetting these obligations, it had cash of US$1.85b as well as receivables valued at US$1.49b due within 12 months. So its liabilities total US$11.0b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$8.07b, we think shareholders really should watch LATAM Airlines Group's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Given net debt is only 0.60 times EBITDA, it is initially surprising to see that LATAM Airlines Group's EBIT has low interest coverage of 1.8 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Pleasingly, LATAM Airlines Group is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 395% gain in the last twelve months. 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 LATAM Airlines 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent two years, LATAM Airlines Group recorded free cash flow worth 73% 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.

Our View

LATAM Airlines Group's EBIT growth rate was a real positive on this analysis, as was its conversion of EBIT to free cash flow. In contrast, our confidence was undermined by its apparent struggle to cover its interest expense with its EBIT. When we consider all the factors mentioned above, we do feel a bit cautious about LATAM Airlines Group's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with LATAM Airlines Group (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.

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