We Think Lingotes Especiales (BME:LGT) Can Stay On Top Of Its Debt

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. We can see that Lingotes Especiales, S.A. (BME:LGT) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Lingotes Especiales

What Is Lingotes Especiales's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Lingotes Especiales had debt of €24.1m, up from €21.4m in one year. However, because it has a cash reserve of €14.9m, its net debt is less, at about €9.20m.

How Healthy Is Lingotes Especiales' Balance Sheet?

We can see from the most recent balance sheet that Lingotes Especiales had liabilities of €40.6m falling due within a year, and liabilities of €16.5m due beyond that. Offsetting these obligations, it had cash of €14.9m as well as receivables valued at €17.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €25.1m.

Lingotes Especiales has a market capitalization of €120.0m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Lingotes Especiales's net debt is only 0.71 times its EBITDA. And its EBIT easily covers its interest expense, being 29.7 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Lingotes Especiales if management cannot prevent a repeat of the 27% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Lingotes Especiales'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Lingotes Especiales recorded free cash flow of 49% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Lingotes Especiales's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about Lingotes Especiales'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. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Lingotes Especiales you should know about.

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. 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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