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. As with many other companies Lenovo Group Limited (HKG:992) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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.
What Is Lenovo Group's Debt?
As you can see below, Lenovo Group had US$3.45b of debt at June 2022, down from US$4.00b a year prior. But on the other hand it also has US$4.01b in cash, leading to a US$556.1m net cash position.
A Look At Lenovo Group's Liabilities
We can see from the most recent balance sheet that Lenovo Group had liabilities of US$33.0b falling due within a year, and liabilities of US$5.69b due beyond that. Offsetting these obligations, it had cash of US$4.01b as well as receivables valued at US$14.8b due within 12 months. So its liabilities total US$19.9b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$9.39b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Lenovo Group would likely require a major re-capitalisation if it had to pay its creditors today. Lenovo Group boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.
Also good is that Lenovo Group grew its EBIT at 17% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Lenovo 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. Lenovo Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Lenovo Group generated free cash flow amounting to a very robust 98% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Although Lenovo Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$556.1m. The cherry on top was that in converted 98% of that EBIT to free cash flow, bringing in US$2.6b. So we are not troubled with Lenovo Group's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Lenovo Group 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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Lenovo Group Limited, an investment holding company, develops, manufactures, and markets technology products and services.
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Undervalued with solid track record and pays a dividend.