Here's Why LY (TSE:4689) Can Manage Its Debt Responsibly

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.' 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. Importantly, LY Corporation (TSE:4689) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for LY

What Is LY's Net Debt?

As you can see below, LY had JP¥1.88t of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had JP¥1.88t in cash, and so its net debt is JP¥5.51b.

How Strong Is LY's Balance Sheet?

The latest balance sheet data shows that LY had liabilities of JP¥3.26t due within a year, and liabilities of JP¥2.33t falling due after that. On the other hand, it had cash of JP¥1.88t and JP¥1.47t worth of receivables due within a year. So its liabilities total JP¥2.25t more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of JP¥2.73t, so it does suggest shareholders should keep an eye on LY's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Carrying virtually no net debt, LY has a very light debt load indeed.

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).

LY has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.015 and EBIT of 185 times the interest expense. So relative to past earnings, the debt load seems trivial. In addition to that, we're happy to report that LY has boosted its EBIT by 35%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if LY can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, LY's free cash flow amounted to 33% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

LY's interest cover was a real positive on this analysis, as was its EBIT growth rate. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that LY is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Be aware that LY is showing 1 warning sign in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.

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