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. As with many other companies LPP SA (WSE:LPP) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is LPP's Net Debt?
As you can see below, at the end of January 2021, LPP had zł1.01b of debt, up from zł581.2m a year ago. Click the image for more detail. But it also has zł1.38b in cash to offset that, meaning it has zł367.9m net cash.
How Healthy Is LPP's Balance Sheet?
According to the last reported balance sheet, LPP had liabilities of zł4.17b due within 12 months, and liabilities of zł3.11b due beyond 12 months. On the other hand, it had cash of zł1.38b and zł358.6m worth of receivables due within a year. So its liabilities total zł5.55b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because LPP is worth zł17.6b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, LPP also has more cash than debt, so we're pretty confident it can manage its debt safely.
Importantly, LPP's EBIT fell a jaw-dropping 82% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine LPP's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While LPP has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, LPP recorded free cash flow worth a fulsome 85% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
While LPP does have more liabilities than liquid assets, it also has net cash of zł367.9m. The cherry on top was that in converted 85% of that EBIT to free cash flow, bringing in zł250m. So although we see some areas for improvement, we're not too worried about LPP's balance sheet. 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 - LPP has 1 warning sign we think you should be aware of.
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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