David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Larsen & Toubro Limited (NSE:LT) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Larsen & Toubro's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Larsen & Toubro had ₹1.47t of debt, an increase on ₹1.35t, over one year. On the flip side, it has ₹511.5b in cash leading to net debt of about ₹954.7b.
How Strong Is Larsen & Toubro's Balance Sheet?
We can see from the most recent balance sheet that Larsen & Toubro had liabilities of ₹1.35t falling due within a year, and liabilities of ₹930.0b due beyond that. Offsetting this, it had ₹511.5b in cash and ₹365.7b in receivables that were due within 12 months. So its liabilities total ₹1.40t more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of ₹2.03t, so it does suggest shareholders should keep an eye on Larsen & Toubro's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With a net debt to EBITDA ratio of 5.7, it's fair to say Larsen & Toubro does have a significant amount of debt. However, its interest coverage of 3.9 is reasonably strong, which is a good sign. Investors should also be troubled by the fact that Larsen & Toubro saw its EBIT drop by 17% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Larsen & Toubro 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Larsen & Toubro created free cash flow amounting to 3.2% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
To be frank both Larsen & Toubro's EBIT growth rate and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. Overall, it seems to us that Larsen & Toubro's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 5 warning signs with Larsen & Toubro (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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