Liberty Shoes (NSE:LIBERTSHOE) Seems To Use Debt Quite Sensibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Liberty Shoes Ltd. (NSE:LIBERTSHOE) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 shore 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Liberty Shoes

What Is Liberty Shoes's Net Debt?

As you can see below, Liberty Shoes had ₹727.6m of debt at September 2022, down from ₹896.8m a year prior. On the flip side, it has ₹35.4m in cash leading to net debt of about ₹692.2m.

How Healthy Is Liberty Shoes' Balance Sheet?

According to the last reported balance sheet, Liberty Shoes had liabilities of ₹1.93b due within 12 months, and liabilities of ₹804.7m due beyond 12 months. On the other hand, it had cash of ₹35.4m and ₹1.22b worth of receivables due within a year. So it has liabilities totalling ₹1.48b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Liberty Shoes has a market capitalization of ₹4.34b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

While Liberty Shoes's low debt to EBITDA ratio of 1.1 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.0 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Also relevant is that Liberty Shoes has grown its EBIT by a very respectable 30% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Liberty Shoes will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Over the last three years, Liberty Shoes recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Liberty Shoes's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its interest cover has the opposite effect. When we consider the range of factors above, it looks like Liberty Shoes is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with Liberty Shoes (at least 1 which shouldn't be ignored) , 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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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.