Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, H. Lundbeck A/S (CPH:LUN) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is H. Lundbeck's Debt?
You can click the graphic below for the historical numbers, but it shows that H. Lundbeck had kr.4.78b of debt in December 2021, down from kr.7.40b, one year before. However, because it has a cash reserve of kr.2.28b, its net debt is less, at about kr.2.50b.
How Strong Is H. Lundbeck's Balance Sheet?
We can see from the most recent balance sheet that H. Lundbeck had liabilities of kr.8.82b falling due within a year, and liabilities of kr.7.56b due beyond that. On the other hand, it had cash of kr.2.28b and kr.2.93b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr.11.2b.
H. Lundbeck has a market capitalization of kr.32.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
H. Lundbeck's net debt is only 0.65 times its EBITDA. And its EBIT covers its interest expense a whopping 15.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for H. Lundbeck if management cannot prevent a repeat of the 22% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 H. Lundbeck'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, H. Lundbeck generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
H. Lundbeck's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Considering this range of data points, we think H. Lundbeck is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Be aware that H. Lundbeck is showing 1 warning sign in our investment analysis , you should know about...
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.