LUG (WSE:LUG) Use Of Debt Could Be Considered Risky

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies LUG S.A. (WSE:LUG) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for LUG

How Much Debt Does LUG Carry?

The image below, which you can click on for greater detail, shows that at September 2020 LUG had debt of zł51.1m, up from zł44.5m in one year. On the flip side, it has zł4.08m in cash leading to net debt of about zł47.0m.

A Look At LUG's Liabilities

The latest balance sheet data shows that LUG had liabilities of zł88.4m due within a year, and liabilities of zł12.6m falling due after that. Offsetting this, it had zł4.08m in cash and zł31.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł65.2m.

Given this deficit is actually higher than the company's market capitalization of zł50.0m, we think shareholders really should watch LUG'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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

LUG has a rather high debt to EBITDA ratio of 6.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.2 times, suggesting it can responsibly service its obligations. On the other hand, LUG grew its EBIT by 20% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since LUG 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, 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. During the last three years, LUG burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both LUG's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider LUG to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Case in point: We've spotted 4 warning signs for LUG you should be aware of, and 2 of them shouldn't be ignored.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. 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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