Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, H. Lundbeck A/S (CPH:LUN) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is H. Lundbeck's Debt?
As you can see below, H. Lundbeck had kr.5.08b of debt at September 2021, down from kr.9.92b a year prior. However, it also had kr.2.50b in cash, and so its net debt is kr.2.58b.
How Strong Is H. Lundbeck's Balance Sheet?
According to the last reported balance sheet, H. Lundbeck had liabilities of kr.9.08b due within 12 months, and liabilities of kr.7.95b due beyond 12 months. Offsetting this, it had kr.2.50b in cash and kr.3.87b in receivables that were due within 12 months. So its liabilities total kr.10.7b more than the combination of its cash and short-term receivables.
H. Lundbeck has a market capitalization of kr.33.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
H. Lundbeck has net debt of just 0.75 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 8.0 times, which is more than adequate. But the bad news is that H. Lundbeck has seen its EBIT plunge 12% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, H. Lundbeck generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
When it comes to the balance sheet, the standout positive for H. Lundbeck was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at (not) growing its EBIT as wet socks are at keeping your feet warm. When we consider all the elements mentioned above, it seems to us that H. Lundbeck is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with H. Lundbeck , 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.
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.
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