We Think L.B. Foster (NASDAQ:FSTR) Is Taking Some Risk With Its Debt

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. We note that L.B. Foster Company (NASDAQ:FSTR) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for L.B. Foster

What Is L.B. Foster's Net Debt?

You can click the graphic below for the historical numbers, but it shows that L.B. Foster had US$37.4m of debt in March 2021, down from US$65.5m, one year before. However, because it has a cash reserve of US$5.02m, its net debt is less, at about US$32.4m.

A Look At L.B. Foster's Liabilities

According to the last reported balance sheet, L.B. Foster had liabilities of US$108.3m due within 12 months, and liabilities of US$89.3m due beyond 12 months. Offsetting these obligations, it had cash of US$5.02m as well as receivables valued at US$65.7m due within 12 months. So it has liabilities totalling US$126.9m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$193.4m, so it does suggest shareholders should keep an eye on L.B. Foster's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 1.2 and interest cover of 3.6 times, it seems to us that L.B. Foster is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Shareholders should be aware that L.B. Foster's EBIT was down 47% last year. 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 ultimately the future profitability of the business will decide if L.B. Foster 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, L.B. Foster recorded free cash flow worth a fulsome 83% 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

L.B. Foster'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. When we consider all the factors discussed, it seems to us that L.B. Foster is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that L.B. Foster is showing 2 warning signs in our investment analysis , and 1 of those is a bit concerning...

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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