Is Larsen & Toubro (NSE:LT) Using Too Much Debt?

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.' 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 note that Larsen & Toubro Limited (NSE:LT) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Larsen & Toubro

How Much Debt Does Larsen & Toubro Carry?

The chart below, which you can click on for greater detail, shows that Larsen & Toubro had ₹1.24t in debt in September 2024; about the same as the year before. On the flip side, it has ₹554.4b in cash leading to net debt of about ₹681.3b.

How Healthy Is Larsen & Toubro's Balance Sheet?

According to the last reported balance sheet, Larsen & Toubro had liabilities of ₹1.95t due within 12 months, and liabilities of ₹553.0b due beyond 12 months. On the other hand, it had cash of ₹554.4b and ₹513.7b worth of receivables due within a year. So it has liabilities totalling ₹1.44t more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Larsen & Toubro has a huge market capitalization of ₹5.04t, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Larsen & Toubro's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 7.0 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We saw Larsen & Toubro grow its EBIT by 8.9% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to 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 Larsen & Toubro'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Larsen & Toubro recorded free cash flow worth 54% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Larsen & Toubro's EBIT growth rate was a real positive on this analysis, as was its interest cover. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that Larsen & Toubro is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Larsen & Toubro is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.