Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Lok'nStore Group Plc (LON:LOK) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Lok'nStore Group's Net Debt?
As you can see below, at the end of January 2021, Lok'nStore Group had UK£53.4m of debt, up from UK£42.4m a year ago. Click the image for more detail. However, it does have UK£11.3m in cash offsetting this, leading to net debt of about UK£42.1m.
A Look At Lok'nStore Group's Liabilities
According to the last reported balance sheet, Lok'nStore Group had liabilities of UK£7.95m due within 12 months, and liabilities of UK£91.4m due beyond 12 months. Offsetting these obligations, it had cash of UK£11.3m as well as receivables valued at UK£2.66m due within 12 months. So it has liabilities totalling UK£85.4m more than its cash and near-term receivables, combined.
Lok'nStore Group has a market capitalization of UK£182.2m, 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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Lok'nStore Group has a debt to EBITDA ratio of 4.6 and its EBIT covered its interest expense 6.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We note that Lok'nStore Group grew its EBIT by 23% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Lok'nStore Group can strengthen its balance sheet over time. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Lok'nStore Group saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Lok'nStore Group's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its EBIT growth rate was re-invigorating. Taking the abovementioned factors together we do think Lok'nStore Group's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Lok'nStore Group you should know about.
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.
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