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.' 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. As with many other companies LY Corporation (TSE:4689) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
View our latest analysis for LY
How Much Debt Does LY Carry?
As you can see below, at the end of December 2023, LY had JP¥1.93t of debt, up from JP¥1.84t a year ago. Click the image for more detail. On the flip side, it has JP¥1.93t in cash leading to net debt of about JP¥590.0m.
A Look At LY's Liabilities
We can see from the most recent balance sheet that LY had liabilities of JP¥3.21t falling due within a year, and liabilities of JP¥2.34t due beyond that. Offsetting this, it had JP¥1.93t in cash and JP¥1.45t in receivables that were due within 12 months. So its liabilities total JP¥2.18t more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of JP¥2.66t, 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).
With debt at a measly 0.0017 times EBITDA and EBIT covering interest a whopping 32.2 times, it's clear that LY is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. And we also note warmly that LY grew its EBIT by 19% last year, making its debt load easier to handle. 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, LY's free cash flow amounted to 32% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Our View
Both LY's ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. 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. However, not all investment risk resides within the balance sheet - far from it. For example - LY has 2 warning signs we think you should be aware of.
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.
New: AI Stock Screener & Alerts
Our new AI Stock Screener scans the market every day to uncover opportunities.
• Dividend Powerhouses (3%+ Yield)
• Undervalued Small Caps with Insider Buying
• High growth Tech and AI Companies
Or build your own from over 50 metrics.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
About TSE:4689
Flawless balance sheet and fair value.
