We Think Deutsche Lufthansa (ETR:LHA) Is Taking Some Risk With Its 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 note that Deutsche Lufthansa AG (ETR:LHA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Deutsche Lufthansa

What Is Deutsche Lufthansa's Net Debt?

As you can see below, Deutsche Lufthansa had €12.4b of debt at June 2023, down from €13.2b a year prior. However, it also had €8.73b in cash, and so its net debt is €3.67b.

How Healthy Is Deutsche Lufthansa's Balance Sheet?

According to the last reported balance sheet, Deutsche Lufthansa had liabilities of €21.0b due within 12 months, and liabilities of €16.2b due beyond 12 months. On the other hand, it had cash of €8.73b and €3.98b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €24.5b.

The deficiency here weighs heavily on the €7.93b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Deutsche Lufthansa would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Deutsche Lufthansa has net debt of just 0.89 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 7.5 times the interest expense over the last year. It was also good to see that despite losing money on the EBIT line last year, Deutsche Lufthansa turned things around in the last 12 months, delivering and EBIT of €2.3b. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Deutsche Lufthansa's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. In the last year, Deutsche Lufthansa's free cash flow amounted to 36% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say Deutsche Lufthansa's level of total liabilities was disappointing. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Looking at the bigger picture, it seems clear to us that Deutsche Lufthansa's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. We've identified 1 warning sign with Deutsche Lufthansa , and understanding them should be part of your investment process.

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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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.