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The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We note that Lar España Real Estate SOCIMI, S.A. (BME:LRE) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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 sure up its balance sheet. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Lar España Real Estate SOCIMI’s Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Lar España Real Estate SOCIMI had debt of €602.4m, up from €541.8m in one year. However, because it has a cash reserve of €207.9m, its net debt is less, at about €394.6m.
How Strong Is Lar España Real Estate SOCIMI’s Balance Sheet?
According to the last reported balance sheet, Lar España Real Estate SOCIMI had liabilities of €60.0m due within 12 months, and liabilities of €630.6m due beyond 12 months. Offsetting these obligations, it had cash of €207.9m as well as receivables valued at €19.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €463.4m.
This is a mountain of leverage relative to its market capitalization of €634.5m. This suggests shareholders would heavily diluted if the company needed to sure up its balance sheet in a hurry. Either way, since Lar España Real Estate SOCIMI does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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.
Strangely Lar España Real Estate SOCIMI has a sky high EBITDA ratio of 9.17, implying high debt, but a strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! It is well worth noting that Lar España Real Estate SOCIMI’s EBIT shot up like bamboo after rain, gaining 77% in the last twelve months. That’ll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Lar España Real Estate SOCIMI’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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Lar España Real Estate SOCIMI produced sturdy free cash flow equating to 79% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Happily, Lar España Real Estate SOCIMI’s impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its net debt to EBITDA. All these things considered, it appears that Lar España Real Estate SOCIMI can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. We’d be motivated to research the stock further if we found out that Lar España Real Estate SOCIMI insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.