Does Grupa LOTOS (WSE:LTS) Have A Healthy Balance Sheet?

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.' 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. As with many other companies Grupa LOTOS S.A. (WSE:LTS) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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.

See our latest analysis for Grupa LOTOS

What Is Grupa LOTOS's Net Debt?

The image below, which you can click on for greater detail, shows that Grupa LOTOS had debt of zł3.21b at the end of March 2021, a reduction from zł3.49b over a year. However, it does have zł1.17b in cash offsetting this, leading to net debt of about zł2.04b.

How Strong Is Grupa LOTOS' Balance Sheet?

According to the last reported balance sheet, Grupa LOTOS had liabilities of zł5.93b due within 12 months, and liabilities of zł4.84b due beyond 12 months. Offsetting this, it had zł1.17b in cash and zł2.55b in receivables that were due within 12 months. So it has liabilities totalling zł7.04b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of zł9.82b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

Given net debt is only 0.97 times EBITDA, it is initially surprising to see that Grupa LOTOS's EBIT has low interest coverage of 2.3 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Shareholders should be aware that Grupa LOTOS's EBIT was down 46% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Grupa LOTOS's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Grupa LOTOS recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Grupa LOTOS's EBIT growth rate and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Grupa LOTOS's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Over time, share prices tend to follow earnings per share, so if you're interested in Grupa LOTOS, you may well want to click here to check an interactive graph of its earnings per share history.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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