These 4 Measures Indicate That Liberty Shoes (NSE:LIBERTSHOE) Is Using Debt Extensively

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.' 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. We can see that Liberty Shoes Limited (NSE:LIBERTSHOE) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Liberty Shoes

What Is Liberty Shoes's Debt?

The image below, which you can click on for greater detail, shows that Liberty Shoes had debt of ₹1.21b at the end of September 2020, a reduction from ₹1.30b over a year. However, because it has a cash reserve of ₹89.0m, its net debt is less, at about ₹1.12b.

How Strong Is Liberty Shoes' Balance Sheet?

According to the last reported balance sheet, Liberty Shoes had liabilities of ₹2.77b due within 12 months, and liabilities of ₹1.05b due beyond 12 months. Offsetting these obligations, it had cash of ₹89.0m as well as receivables valued at ₹1.77b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.97b.

This deficit is considerable relative to its market capitalization of ₹2.42b, so it does suggest shareholders should keep an eye on Liberty Shoes' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Even though Liberty Shoes's debt is only 1.9, its interest cover is really very low at 0.80. The main reason for this is that it has such high depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Shareholders should be aware that Liberty Shoes's EBIT was down 65% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Liberty Shoes's earnings that will influence how the balance sheet holds up in the future. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Liberty Shoes recorded free cash flow worth a fulsome 100% 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

To be frank both Liberty Shoes's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Liberty Shoes stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Liberty Shoes is showing 3 warning signs in our investment analysis , and 2 of those are a bit unpleasant...

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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