These 4 Measures Indicate That LA Holdings (TSE:2986) Is Using Debt In A Risky Way

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that LA Holdings Co., Ltd. (TSE:2986) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for LA Holdings

How Much Debt Does LA Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 LA Holdings had JP¥43.4b of debt, an increase on JP¥37.8b, over one year. However, because it has a cash reserve of JP¥6.86b, its net debt is less, at about JP¥36.6b.

A Look At LA Holdings' Liabilities

We can see from the most recent balance sheet that LA Holdings had liabilities of JP¥22.1b falling due within a year, and liabilities of JP¥24.8b due beyond that. Offsetting these obligations, it had cash of JP¥6.86b as well as receivables valued at JP¥1.00m due within 12 months. So its liabilities total JP¥40.0b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of JP¥29.6b, we think shareholders really should watch LA Holdings's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

LA Holdings's net debt to EBITDA ratio is 8.2 which suggests rather high debt levels, but its interest cover of 7.2 times suggests the debt is easily serviced. Our best guess is that the company does indeed have significant debt obligations. Shareholders should be aware that LA Holdings's EBIT was down 31% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is LA Holdings'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.

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. Over the last three years, LA Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, LA Holdings's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. After considering the datapoints discussed, we think LA Holdings has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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 LA Holdings has 4 warning signs (and 2 which are a bit unpleasant) we think 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.