Is Lands' End (NASDAQ:LE) A Risky Investment?

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.' 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. Importantly, Lands' End, Inc. (NASDAQ:LE) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Lands' End

What Is Lands' End's Debt?

As you can see below, Lands' End had US$278.8m of debt at July 2021, down from US$381.9m a year prior. However, because it has a cash reserve of US$39.2m, its net debt is less, at about US$239.5m.

A Look At Lands' End's Liabilities

According to the last reported balance sheet, Lands' End had liabilities of US$361.4m due within 12 months, and liabilities of US$354.5m due beyond 12 months. Offsetting these obligations, it had cash of US$39.2m as well as receivables valued at US$30.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$646.4m.

This is a mountain of leverage relative to its market capitalization of US$812.0m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

Lands' End has net debt worth 1.8 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 2.7 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Pleasingly, Lands' End is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 122% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Lands' End can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Lands' End's free cash flow amounted to 39% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Lands' End's ability to cover its interest expense with its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that Lands' End's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Lands' End (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

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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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.
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