Is LB Group (SZSE:002601) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 LB Group Co., Ltd. (SZSE:002601) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for LB Group

What Is LB Group's Debt?

As you can see below, at the end of March 2024, LB Group had CN¥23.2b of debt, up from CN¥19.5b a year ago. Click the image for more detail. However, because it has a cash reserve of CN¥8.23b, its net debt is less, at about CN¥14.9b.

A Look At LB Group's Liabilities

The latest balance sheet data shows that LB Group had liabilities of CN¥27.4b due within a year, and liabilities of CN¥12.5b falling due after that. Offsetting these obligations, it had cash of CN¥8.23b as well as receivables valued at CN¥5.97b due within 12 months. So it has liabilities totalling CN¥25.7b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since LB Group has a market capitalization of CN¥52.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

LB Group's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its commanding EBIT of 12.7 times its interest expense, implies the debt load is as light as a peacock feather. Also relevant is that LB Group has grown its EBIT by a very respectable 29% in the last year, thus enhancing its ability to pay down debt. 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 LB Group 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, LB Group actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Both LB Group's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to convert EBIT to free cash flow. Looking at all this data makes us feel a little cautious about LB Group's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with LB Group (including 1 which doesn't sit too well with us) .

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.